Introduction and Directions
Fractional-reserve banking is a system in which banks are required to hold only a fraction of their deposits (reserve requirement) available for withdrawal by depositors. The rest may be lent, thus “creating” money.
When depository institutions make loans, they create money because these loans become new deposits from which borrowers can withdraw cash to spend. The size of the reserve requirement has a direct impact on the amount of money that can be created when depository institutions make loans.
The money multiplier is the mathematical relationship between the monetary base and money supply of an economy. It explains the increase in the amount of circulated money that is created when a bank makes loans using funds previously deposited by customers.