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# Overview of fractional reserve banking

Central banks create money by printing it or making electronic money. They put money into circulation by buying securities, like government debt. Banks use fractional reserve lending, keeping a portion of deposits and lending the rest. This process multiplies the money in the economy. Checks help money move without being withdrawn. Created by Sal Khan.

## Want to join the conversation?

• -Why when the banks are giving loans to the following banks does their money 'in-house' not become reduced to 1\$? I don't understand why 3\$ could physically turn into 6\$ if no more dollars were printed. (conservation of mass?)
• If Bank A lends to Bank B, Bank A gets to claim that owed money as an asset on it's books as does Bank B because it actually has the money or its electronic equivalent. So, for example, if you have 100 dollars, and you loan your buddy 50 dollars, you can say you have 100 dollars in assets ( the 50 you have and the 50 you are owed) and your buddy can say he has 50 dollars in assets. The total is now 150 dollars. Then your buddy lends 25 dollars to his mom. He can claim 50 dollars in assets ( 25 in hand and 25 owed) and his mom can claim she has 25 dollars. The total is now your 100, your buddy's 50, and his mom's 25 for a total of 175 dollars that everybody says they "have" from the original 100. Of course it is really 100, but the key is that everybody is now acting(spending) like they have money and this drives the economy. If your buddy and his mom would have waited until they actually had un-borrowed money to spend, the thought is that the economy would suffer from inactivity.
• @ Sal said 'they go out into the open market and buy securities' what exactly are 'securities'? He has mentioned them several times in other videos, and I still don't know what they are.
• when someone or a company buys bonds, they are essentially lending out money. the bonds are certificates that guarantee repayment of your money that you invested to buy the bond, along with a pre-determined interest. securities are any tradable assets, such as stocks, banknotes, etc. Bonds are one type of security.
• Fractional reserve banking increases the money supply by lending out the money multiple times over -- so doesn't this by nature result in debt (that cannot be paid back) and/or inflation.
• The principle and interest can be paid back because the interest paid to depositors, operating costs of the bank, and profits all have a path back into the economy. Fractional reserve banking facilitates an increase in the velocity of money; as such it does impact inflation. The bank's cash reserve limit and the limits of banking technology prevent the velocity of money from increasing indefinitely. The choices of all agents in the economy to spend, save, or borrow determine the actual velocity of money.
• @2.05 I want to see if I understand this. The government will buy securities and the newly created money used to buy these securities then enters the economy as "new money". So when the government collects on the security at its maturation that money will be government revenue? Is there a reason that the government cannot just add the newly created money into its programs as additional revenue?
• You are confusing the government with the central bank. The government sells securities in order to raise money for its programs. The central bank then buys those securities and the money used will enter the economy. At maturation, the government pays the owner of the security (the central bank) back the principal and some interest. That money will go out of the economy, but fortunately (maybe?) the central bank can buy newer government securities. This will continue to work as long as the government is in debt.
• Are the banks required to keep only a certain amount on reserve and lend out the rest, or can they hold on to all of it if they want?
• They don't have to lend, but they want to, otherwise they are paying interest to depositors and they are not earning any interest on the money they have not lent out. So, typically what they will do with money they have not lent to individuals is to lend it to the US government by buying treasury bonds.
• So if everyone were to go any try to withdraw all of their money at once, would our entire economy collapse entirely?
• Yes, pretty much. That's called a bank run, and that's why we have deposit insurance and it's also why the Fed can lend money to banks that are short on reserves, as a last resort.

With deposit insurance, there is no reason for everyone to try to withdraw money all at once, since they are guaranteed to be able to get their money at any time. And if too many withdrawals do occur, the Fed can step in and make unlimited loans to banks so that they can cover the withdrawals. Bank runs were common before we had deposit insurance and the Fed. Now they are unheard of (in the US).
• How does the Dodd-Frank Act affect this model?
• I would type in Dodd-Frank Act to find out more about it.
(1 vote)
• Now we know the true reason of ATM withdrawl limits per day.