Money Creation Through The Fractional Reserve System
Through fractional-reserve banking, the modern banking system expands the money supply of a country beyond the amount initially created by the central bank. There are two types of money in a fractional-reserve banking system, currency originally issued by the central bank, and bank deposits at commercial banks:
- central bank money (all money created by the central bank regardless of its form, e.g. banknotes, coins, electronic money)
- commercial bank money (money created in the banking system through borrowing and lending) - sometimes referred to as checkbook money
When a commercial bank loan is extended, new commercial bank money is created. As a loan is paid back, more commercial bank money disappears from existence. Since loans are continually being issued in a normally functioning economy, the amount of broad money in the economy remains relatively stable. Because of this money creation process by the commercial banks, the money supply of a country is usually a multiple larger than the money issued by the central bank; that multiple is determined by the reserve ratio or other financial ratios (primarily the capital adequacy ratio that limits the overall credit creation of a bank) set by the relevant banking regulators in the jurisdiction.
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