MATTOLE SELF-SUFFICIENCY PROJECT

How Fractional Reserve Banking Works

Once money is transferred to the reserve account of a commercial bank, that bank can issue loans up to 85% of its reserves. Suppose that you borrow $850 from your bank. In order to make the loan, your bank must have $1000 available in its reserve account at the regional Federal Reserve Bank. The $1000 remains on reserve at the FRB and your bank creates the $850 that it lends you as a book-keeping entry in its computer database.

Suppose that you use this $850 to buy a stereo set. The owner of the store where you bought the stereo deposits your $850 into his/her account. This $850 is then added to the reserves for that bank, also held in its regional FRB. That bank can now make a loan of 85% of that $850 or $722.50, again creating the $722.50 as a book-keeping entry in its database.

The original $1000 has now been lent out as two loans, one for $850 and a second for $722.50, a total of $1572.50. And, interest is being collected on both. Of course, that $722.50 will wind up in a third bank and become part of its reserves and part of a third loan ($614.12) and so forth. Potentially, the original $1000 could result in $5,666.66 in loans, all of which are interest-bearing and all of which were created out of thin air.

Last Updated: 23 Mar 2005