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Fractional reserve banking is the banking system most countries use today.

It requires banks to hold only a fraction of the money their customers deposit. That amount is the reserve requirement, and in most countries it’s set by the central bank. Banks can loan the rest of their deposits to other customers, which serves to expand the economy.

It works like this:

Banks accept deposits from individuals and businesses, providing them with savings and checking accounts in return. Banks can loan out the bulk of those deposits to other customers to buy homes or cars, start businesses or to fund other projects.

If a customers deposits $100,000 into a bank, and the reserve requirement is 5%, the bank can loan $95,000 out to other customers.

Once the bank has loaned out $95,000, it in essence has created $195,000. Customers borrow that $95,000 and deposit some, or all, of it into other banks. If the reserve requirement is still 5%, then the other banks can loan $90,250 to new customers. And the process keeps repeating itself.

Financial crises occur when the fractional banking system breaks down and the money supply does not expand.

Many U.S. banks had to shut down during the Great Depression because so many people attempted to withdraw their money at the same time. Today, safeguards exist to prevent such an occurrence.

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