Final answer:
Fractional reserve banking enables banks to create money by issuing loans greater than the cash they hold, thereby increasing the money supply through a multiplier effect. The process is supported by repeat deposits and lending within the banking system. Similarly, the Federal Reserve increases the money supply by purchasing assets and crediting banks' reserves.
Step-by-step explanation:
Fractional Reserve Banking and the Creation of Money
Fractional reserve banking is a system in which banks are required to keep only a fraction of their deposits as reserves. This system allows banks to create money 'out of thin air' by issuing loans that exceed their actual cash on hand. Here's a simplified breakdown of how this happens:
A bank receives a deposit and keeps a fraction of it as reserves; the rest can be lent out.
The loan is deposited into another bank, increasing that bank's deposits.
This second bank then keeps a fraction as reserves and can make new loans from the remaining amount.
The process repeats, with each round of lending and depositing leading to an increase in the total money supply.
This chain reaction of depositing and lending can significantly increase the money available in an economy beyond the initial cash deposited, effectively creating money 'out of thin air.' However, it's essential to note that while banks can create money through loans, they are still subject to regulatory constraints such as reserve requirements and capital adequacy ratios.
When it comes to the Federal Reserve, the process works similarly but on a larger scale. The Federal Reserve has the authority to create money, which it does by purchasing assets such as government bonds. Here, the Federal Reserve 'writes a check' to the selling bank, thus increasing that bank's reserves and the overall money supply without any physical cash changing hands. This demonstrates the Federal Reserve's unique ability to expand the money base.