FRACTIONAL RESERVE SYSTEM

also called Minimum Reserve System, banking system followed by all modern banks in which less than 100 percent of bank deposits are held as reserves. The portion of the money not held as reserves is used to earn income by means of loans and investments; some of this portion eventually returns to the banking system as new deposits. Thus, the banking system is able to expand the money supply through the creation of new demand deposits. Banks do not have unlimited freedom to expand deposits but must usually maintain required reserves, which may be held as currency or as deposits at the central bank. The ratio of the required reserves to a bank's total deposits may be set by custom or by law; use of legally required reserves appears to have originated in the United States. The fractional reserve system is strengthened by the ability of banks to liquidate some of their assets quickly by calling in loans, selling short-term securities, or borrowing cash from the central bank.