Final answer:
Fractional reserve banking allows banks to extend loans exceeding their cash reserves, a process critical for money creation in the economy. This enables the value of loans to surpass the amount kept in reserve, but it requires careful management and regulation to ensure financial stability.
Step-by-step explanation:
Fractional reserve banking is a system that allows banks to lend out more than the value of their cash reserves. This is possible because banks are required to keep only a fraction of their depositors' funds as reserves, either in their vaults or at the Federal Reserve Bank, known as the reserve requirement. Banks can also protect against risks by holding a greater proportion of their assets in bonds and reserves or by diversifying their loans. When banks lend out their deposits, those funds are usually deposited back into the banking system, creating additional reserves that can be loaned out again. This process can multiply the money supply in the economy through what is known as the money multiplier.
The correct answer to the question - Fractional reserve banking is useful for banks because it allows the value of loans to exceed the value of cash reserves. This mechanism plays a critical role in money creation within an economy by enabling banks to lend more than they hold in immediate reserves. However, it also necessitates careful regulation and reserve management to ensure that banks remain solvent and can meet withdrawal demands.