How does the fractional reserve requirement constrain banks in money creation?

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pohnpei397 eNotes educator| Certified Educator

The fractional reserve requirement constrains banks’ ability to create money because it does not allow them to loan out all of the reserves which they take in. 

When people deposit money in banks, the banks do not simply put the money in the vault and let it sit there.  Instead, they make investments using the money.  They make loans and they make other investments.  When they do this, they are increasing the supply of money.  The supply of money  increases because, in essence, when the bank loans out the money, the amount of money multiplies. The person who deposited the money still has that money.  That person can withdraw it at any time.  At the same time, however, the person who borrowed the money has that money too.  Through banking and lending, the money has duplicated itself.

The fractional reserve requirement reduces the ability of banks to do this.  They cannot lend out all their money.  Instead, they must keep some in the bank.  This means that only a fraction of the money can be loaned out.  Without this requirement, banks could essentially create unlimited amounts of money because they could loan the same money out time and time again.  With the reserve requirement, this cannot be done indefinitely because they amount of money being loaned decreases a little bit each time it is loaned.  In this way, reserve requirements reduce banks’ ability to create money.