Ever wondered how our fractional reserve system works. How $100 printed by Federal Reserve (Fed) can generate a $1000 worth of economic activity (assume a 10% reserve requirement). Fractional reserve requirement is the percentage of money that a commercial bank has to keep with Central Bank as reserve (Currently it is 10% in United States). In this post, I will try to briefly explain how this "borrow from Peter to pay Paul" type system works.
Lets say the Feds decide to float $100,000 in the market. They do this by writing a blank check against themselves and buying Treasuries in open market worth $100,000. This buying releases $100,000 in the banking system.
Lets say Bank-B1 decides to sell $100,000 worth of Treasury bill to Feds.
* The result would be B1 will have $100,000 to loan.
* B1 lends $90,000 to Paul who wants to buy land from John. ($90,000 because $10,000 has to be kept in reserves due to reserve requirement).
* John deposits the amount $90,000 that he received in bank-B2.
* B2 lends $81,000 (keeping $9,000 in reserves) to Peter who uses it to buy a fleet of cars from Mary
* Mary deposits $81,000 in bank-B3. B3 in turn lends $72,900 (Keeping $8,100 in reserves) to Jim who wants to upgrade his kitchen by contracting the work to Home Depot.
* Home Depot then deposits $72,900 in bank-B4 and the chain continues.
The total worth of economic activity generated (in dollar terms) can be computed by summing up all the activities described above. All these activities can be expressed as a geometric sequence whose sum can be computed by using standard geometric progression formula:
100,000*(1 + 0.9 + (0.9)^2 + (0.9)^3 + .....infinite series) = 100,000/(1-0.9) = 1000,000
The overnight lending between the banks and Central Bank keeps the capital fully tied up (in terms of loan) and keeps the economy flowing. Any stagnation in lending between the banks will cut that geometric series (described above) short and hampers the capitalist economy.
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