I'm sure you've heard someone say to you before "hey bro money's not even real" before they go ahead and purchase something dumb. But it turns out your likely drunk friend isn't too far from the truth.

Fractional reserve banking is an obligation for banks to keep a certain percentage of deposits in reserve, usually set at 10%.

This is a fun thing to work through, because it's usually a rather confusing thing to think about how that reserve requirement creates new money in the economy.

But I'll give explaining it my best shot with an example that doesn't include me using several items on a Wetherspoons table.

Ok, so let's say you deposit $10,000 into Bank A.

The bank only keeps 10% so in reality the money that actually stays with Bank A is only $1,000.

So where does that $9,000 go?

Well the bank usually lends it out to businesses or individuals. And what do those individuals usually do with a bank loan?

They keep it in a bank.

So $9,000 ends up in Bank B in this example.

Bank B is still bound by the same 10% reserve requirement as Bank A, so it keeps $900 of the deposit and lends out $8,100.

Where does that $8,100 go? You guessed it.

Bank C takes it as a deposit.

And Bank C only keeps 10% ($810) and lends out the rest. See what's happening here?

The key thing to remember is that while banks are only obligated to keep 10% of deposits, they still owe you 100% of your money back.

So let's revisit the example here.

Each person banking with A, B and C are all owed 100% of their deposit should they request it. So all of them effectively have a claim on:

• $10,000
• $9,000
• $8,100

That brings the total owed money to $27,100 from an initial deposit of $10,000.

Of course this cycle keeps going until the amounts get so insignificant it's not worth counting anymore but as a rule of thumb with a 10% fractional reserve requirement you can expect the deposited amount to 10x in value.

You can see this if you play out the math:

$10,000 (Bank A) + $9,000 (Bank B) + $8,100 (Bank C) + $7,290 (Bank D) + $6,561 (Bank E) + and so on.

So why is this a good thing?

Well, this system effectively allows the money supply to increase without the need to print actual notes. That means more money can be loaned out for productive uses like investment, business expansion or consumption.

The increase in money supply also allows banks to lend much more money to various sectors of the economy supporting job creation and innovation.

And of course it makes sense for the banks, they can make money by lending out deposits to further expand their operations and grow as businesses.

What are the negatives?

There's actually a lot!

Inflation - that's the hot one on everyone's mind. Fractional reserve banking is an effective contributor towards inflation in a few ways:

1. Demand pull inflation: Amount of goods remains the same while the amount of money in the system increases through lending. This means more money chases the same amount of goods. So the price of goods goes up because most bidders suddenly have more money.

2. An amplification effect: the more banks loan, the more money is in the system, creating even more bidders with even more money to spend on the same amount of goods and services.

3. Asset price inflation:in the real world, all this money doesn't go only to goods and services, a lot of it ends up in assets. Increased credit availability often leads to inflated prices in the real estate and stock markets as more money is injected into these sectors.

4. Indirect contribution to cost-plus inflation: This is where businesses borrow a lot of money from banks to expand or cover costs, increasing demand for raw materials and labour. As businesses compete over limited labour and resources, the prices of these assets are driven up causing businesses to spend more and therefore have to push higher prices onto consumers.

Fractional reserve banking is more famously known for causing serious bank runs.

Since banks only hold a small portion of the true money that is owed to the customer, if enough customers demanded withdrawals in full the bank would run out of money on hand to meet demand. A recent one that made headlines was Silicon Valley Bank which had to process over $42 billion in withdrawals in one day⁽¹⁾.

Another nasty thing that fractional reserve banking can cause is overextension of credit sometimes creating massive debt bubbles where people and businesses take on way more debt than they can afford to repay. If enough people fail to pay back their loans it can destabilise the whole financial system and cause spectacular collapses like the Chinese Evergrande group defaulting on over $300 billion of debt ⁽²⁾.

To conclude, your friend was partly right, most money isn't real - it's created through many bank deposits of lended money.