In economics, particularly in financial economics, fractional-reserve banking is the near-universal practice of banks of retaining only a fraction of their deposits to satisfy demands for withdrawals, lending the remainder at interest to obtain income that can be used to pay interest to depositors and provide profits for the banks' owners. Fractional-reserve banking allows for the possibility of a bank run in which the depositors collectively attempt to withdraw more money than is in the possession of the bank, leading to bankruptcy. This is possible because both the borrower and the depositor have a claim to withdraw money deposited at the bank. It also increases the money supply through a mechanism called the deposit creation multiplier, explained below, which leads to inflation by definition. Most governments impose strictly-enforced reserve requirements on banks, with the exact fraction of deposits that must be kept in reserve generally set by a central bank.
A deposit creation multiplier measures the amount by which commercial banks increase the money supply. Central banks generally restrict the proportion of primary deposits that commercial banks can lend out. This is called the cash reserve ratio. For example, lets assume that a primary deposit of $1000 is made into bank A. If the cash reserve ratio is 12%, then $120 must be kept on hand by the bank and $880 is available to be lent to someone else (called the excess reserve). Now if bank A uses its $880 in excess reserve by lending it out, and that is deposited in bank B, it represents a primary deposit to the second bank. Bank B must keep 12% of $880 on hand but can lend out $774.40. If that $774.40 is eventually deposited in bank C, the third bank must keep $92.93 on hand but can lend out $681.47. The process continues until there is no excess reserve left (For simplicity we will ignore safety reserves.). By adding all the derivative deposits we can calculate the amount of money created. Alternatively we can use the deposit multiplier equation:
TD = ID / crr Where: TD=change in Total Deposits ID=Initial change in Deposit ccr=cash reserve ratio
The initial change in deposit of $1000 will increase total deposits by $7333.33 given a reserve ratio of 12% (1000/.12=8333.33). In actual fact, the money creation multiplier is more complex than this simple description. We must add to the equation the currency drain ratio (the propensity of the public to hold cash rather than deposit it in the banking system),the clearing house drain (the loss of deposits from the system due to interactions between banks), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold - usually a very small amount). Also, most jurisdictions require different levels of reserves for different types of deposits. Foreign currency deposits, domestic time deposits, and government deposits often have different cash reserve ratios.