Lecture Notes: Chapter 32 - Fractional Reserve Banking System

Recap of Previous Class

• Fractional Reserve Banking System
  • Historical context: Initially, reserves were in forms of gold, now it's depositor's money.
  • Creation of Money: Banks lend depositors' money to others for profit (interest on loans).
  • Consequences: More money in circulation than actual reserves.

Characteristics of Fractional Reserve Banking

• Banks are susceptible to bank panics or runs: If many depositors withdraw at once, banks may lack liquidity.
• Central Bank Role: Manages money supply to prevent inflation caused by the excessive lending.
  • Monetary Policy: Tool for controlling the money supply.

Reserve Requirement

• Definition: Regulation requiring banks to hold a portion of deposits as reserve.
  • Also known as required reserve or statutory reserve requirement.
• Purpose: Limits commercial banks' ability to create money through loans.

Factors Affecting Reserve Requirement

1. Amount of Deposits
   • Larger deposits require larger reserves.
   • Example: Maybank vs. smaller banks like Bank Moala.
2. Reserve Ratio
   • Percentage set by the central bank indicating reserves needed.
   • Changes based on economic goals (e.g., inflation or recession control).

Calculation of Required Reserve

• Dependent on total deposits and reserve ratio.
• Example Calculation:
  • Deposits: $100,000, Reserve Ratio: 20% = Required Reserve: $20,000.

Changes in Deposits and Reserve Ratio

• Deposits Increase: Raises required reserve and excess reserve.
• Reserve Ratio Increase: Raises required reserve but lowers excess reserve.

Excess Reserve

• Definition: Actual reserve minus required reserve.
• Importance: Determines the amount banks can loan out.

Impact of Excess Reserve

• Loan Capacity: Excess reserve limits the total loans a bank can issue.
• Money Supply: Affects the creation of new money in the economy.

Summary

• Higher Reserve Ratio: Higher required reserve, less excess reserve, reduced loan capacity, smaller money supply.
• Central banks control money supply through reserve requirements and ratios, which in turn affect bank lending and money creation.