Fractional reserve banking is the system of banking that creates the money supply. Simply put it is the standard in which banks create money to lend, create cash flow, and earnings for the bank. The process allows a bank to lend funds that are left for deposit by bank customers in their “on demand” accounts such as checking, savings and certificate of deposits. Banks keep on reserve 10 percent of all deposits recognizing that bank customers will not withdraw their deposited funds at the same time. This calculated risk by the banks not only creates the ability to lend the 90 percent of deposited funds to others generating additional funds through the interest rates charged on loans but it creates an inflated money supply throughout the community.

For example, bank customers deposit $1,000,000 into various on demand accounts. The bank now has $900,000 to lend out to customers that utilize these funds to recirculate back into the system or community. In the case of a business loan made to a local contractor it is expected that the contractor utilizes these funds to purchase new tools, vehicles, and create employment opportunities. The employees will then have paychecks which they in turn deposit into the lending bank or other community lending banks which now creates more on demand funds which the banks utilize in the same manner, ten percent reserve and ninety percent to put back into the community which in turn creates additional funds for the system ad infinitum.

On the flip side of the coin there are substantial potential dangers created by this system of banking. First is the inability to continue ad infinitum. People do withdraw their funds, interest rates must be charged in proportion to the growth of the economy which in turn creates the danger of recession and potential economic depression. An additional dander arises when lending institutions increase risk by leveraging their reserves or diminishing them below acceptable rates.