The banking system in the U.S. is based on:
A) 100 percent reserve banking.
B) fractional reserve banking.
C) 0 percent reserve banking.
D) none of the above.
The correct answer and explanation is :
The correct answer is B) fractional reserve banking.
Explanation:
The banking system in the United States operates primarily under a fractional reserve banking system. This means that banks are required to keep only a fraction of their deposits in reserve as cash or liquid assets, while the rest can be lent out to borrowers. In other words, banks do not need to hold 100% of the money that customers deposit with them, and they can create money through the lending process.
Key Features of Fractional Reserve Banking:
- Reserve Requirement: The Federal Reserve, which is the central bank of the United States, sets a reserve requirement ratio, which determines the minimum fraction of deposits that a bank must hold in reserve. For example, if the reserve requirement is 10%, a bank must keep 10% of its deposits in reserves and can lend out the remaining 90%. However, the exact reserve ratio may vary depending on the type of deposit or the size of the bank.
- Money Creation: Through fractional reserve banking, banks play a crucial role in the creation of money. When a bank lends out a portion of the deposits, it essentially creates new money in the economy. This is because the borrower will spend the loan, and that money will likely be deposited into another bank, which can then lend out a portion of those deposits, continuing the cycle. This process multiplies the amount of money in circulation.
- Implications for Liquidity: While fractional reserve banking allows for economic growth by enabling more lending and investment, it also introduces risks. If too many depositors demand their money back at the same time (a “bank run”), the bank may not have enough reserves to meet the demand, leading to potential insolvency.
In contrast, 100 percent reserve banking (Option A) would require banks to hold all deposits in reserve, which is not how the U.S. system functions. 0 percent reserve banking (Option C) would imply no reserve requirements, which would be impractical and could lead to extreme instability.
Thus, fractional reserve banking is the foundation of the U.S. banking system.