Fractional reserve banking is a system that allows banks to hold only a fraction of their deposits as reserves while lending out the rest. This system is used by most modern banks and it plays an important role in the economy by allowing banks to create money and make loans, which can help to fuel economic growth.

Under a fractional reserve banking system, banks are required to hold a certain percentage of their deposits as reserves. These reserves can be in the form of cash or other liquid assets, such as government bonds. The percentage of deposits that must be held as reserves is known as the reserve ratio. This ratio is set by the central bank, which is responsible for regulating the banking system.

When a customer deposits money into a bank, the bank can use a portion of that money to make loans to other customers. For example, if a bank has a reserve ratio of 10%, and a customer deposits $100 into the bank, the bank can lend out $90 of that money to other customers. This process is known as fractional reserve lending.

Fractional reserve banking has several important benefits. For example, it allows banks to create money by making loans. When a bank makes a loan, it creates new money by crediting the borrower’s account with the loan amount. This creates a multiplier effect, which can help to increase the money supply in the economy. Additionally, fractional reserve banking allows banks to make loans to businesses and individuals who may not have enough money to borrow from other sources, which can help to fuel economic growth.

However, fractional reserve banking also has some drawbacks. For example, if too many customers withdraw their deposits at the same time, it can cause a bank run, which can lead to bank failures. Additionally, fractional reserve banking can lead to inflation if the money supply grows too fast.

In conclusion, fractional reserve banking is a system that allows banks to hold only a fraction of their deposits as reserves while lending out the rest. This system is used by most modern banks and it plays an important role in the economy by allowing banks to create money and make loans, which can help to fuel economic growth. However, it also has some drawbacks, such as the risk of bank runs and inflation, which must be managed by the central bank and regulatory authorities.