Full Reserve Banking vs. Fractional Reserve Banking Flashcards
What is the key difference between full reserve banking and fractional reserve banking?
Full reserve banking requires banks to hold 100% of demand deposits in reserve, while fractional reserve banking allows them to lend out a portion of those deposits.
Why is full reserve banking considered safer for depositors?
In full reserve banking, your money is always available in the bank’s reserves. There’s almost no risk of bank runs because depositors know their funds are secure.
How does fractional reserve banking stimulate economic growth?
By lending out a portion of deposits, fractional reserve banking increases the money supply. This makes loans more accessible, potentially fueling investment, business expansion, and consumer spending which leads to economic growth.
What is the major risk associated with fractional reserve banking?
If too many depositors try to withdraw their funds at once (a bank run), the bank might not have enough reserves to cover everyone. This can lead to bank failures and instability in the financial system.
Does India use a full reserve or fractional reserve banking system?
India uses a fractional reserve banking system.
In a full reserve banking system, how do banks make profits?
Banks in a full reserve system primarily earn profits by:
Charging fees for services like safekeeping, account management, and wire transfers.
Lending from time deposits (which have a fixed withdrawal period)
What is a reserve requirement?
A reserve requirement is the percentage of deposits that banks must hold in reserve as cash or deposits with the central bank, instead of lending it out. This is a key tool used in fractional reserve banking.
How does fractional reserve banking lead to the creation of new money?
Here’s a simplified example:
You deposit $1000.
The bank keeps 10% ($100) in reserve and lends out $900.
The borrower of that $900 might deposit it in their own bank.
That bank keeps 10% ($90) as reserve and lends out $810.
This process repeats, effectively increasing the money supply beyond the initial $1000 deposit.
What are some arguments in favor of full reserve banking?
Advocates of full reserve banking argue that it:
Prevents bank runs and financial instability
Limits banks’ power to create excess money which could lead to inflation
Provides a more transparent and less risky system
What are some arguments against full reserve banking?
Critics of full reserve banking argue that it:
Severely restricts lending, potentially hindering economic growth
Might lead to higher fees for consumers to make up for lost lending profits
Could concentrate even more power in the hands of the central bank
What is the “money multiplier” effect in fractional reserve banking?
The money multiplier describes how an initial deposit can lead to a larger expansion of the money supply through the fractional reserve lending process. The formula is: Money Multiplier = 1 / Reserve Requirement.
Example: With a 10% reserve requirement, the money multiplier is 10 (1 / 0.10). This means an initial $1000 deposit could potentially lead to a $10,000 increase in the money supply through the lending process.
What are some tools central banks use to manage fractional reserve banking systems?
Reserve requirements: Setting the minimum reserve ratio banks must maintain.
Open market operations: Buying or selling government bonds to influence the money supply.
Interest rates: Setting the interest rate at which banks can borrow from the central bank, influencing lending rates in the broader economy.
Deposit insurance: Providing government guarantees for deposits to boost confidence in banks.
