Final answer:
Fractional reserve banking can impact the trade balance, external financing needs, and exchange rate of a country. It may lead to increased imports, higher demand for external financing, and currency depreciation.
Step-by-step explanation:
A fractional reserve banking system is a form of banking in which banks keep only a fraction of their deposits as reserves and lend out the rest. This system has several impacts on the trade balance, external financing needs, and exchange rate of a country.
Firstly, fractional reserve banking can impact the trade balance. When banks create new money through lending, it increases the money supply in the economy, which in turn can lead to an increase in aggregate demand. This increase in aggregate demand may lead to higher imports, potentially widening the trade deficit.
Secondly, fractional reserve banking can impact a country's external financing needs. If banks create money by lending, it increases the domestic credit and borrowing. This may lead to a higher demand for foreign capital to finance domestic borrowing needs. Therefore, countries with a fractional reserve banking system may have a greater need for external financing.
Lastly, fractional reserve banking can have an impact on the exchange rate. If domestic banks borrow from abroad, it can result in an increase in the demand for foreign currency, leading to a depreciation of the domestic currency. This depreciation can make imports more expensive and exports more competitive, potentially affecting the exchange rate.