Fractional-reserve banking is a banking system (currently practiced in most countries worldwide) in which only a fraction of bank deposits are backed by actual cash-on-hand and are available for withdrawal. In other words, contrary to full-reserve banking, only a fraction of a bank’s demand deposits are kept in reserve and available for immediate withdrawal. Therefore, when you deposit $100, the bank will keep only a small fraction of your money in reserve and lend out the rest of your money. It implies that fractional-reserve banking expands credit and money supply beyond the amount of the underlying reserves of base money originally created by the central bank. The proponents of this system argue that fractional reserve banking allows for capital investment and economic growth in excess of what a full-reserve system would allow. The opponents believe that the fractional-reserve banking causes macroeconomic instability.
Fractional-Reserve Banking and Gold
Fractional reserve banking makes banks vulnerable to bank runs (they keep only a fraction of deposits in a reserve, therefore they are insolvent in some sense). Moreover, the fractional-reserve banking system allows banks to create money. According to the Austrian business cycle theory, the expansion of credit and money supply leads to the business cycle and systemic crises. Therefore, fractional-reserve banking causes macroeconomic instability, which creates the demand for safe-haven assets, such as gold. Indeed, the shiny metal may be considered as a bet against the current monetary system based on the fiat U.S. dollars and fractional-reserve banking.
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