Understanding the Functioning of the Fractional Reserve System

###The concept of fractional reserve in the banking system

Fractional reserve is a fundamental mechanism in the modern banking system. This system allows financial institutions to utilize a significant portion of their clients' deposits to grant loans, keeping only a small fraction as reserve. In practice, this mechanism creates money out of nothing, using a percentage of clients' bank deposits.

Financial institutions are required to maintain a minimum percentage of deposits in their accounts, being able to lend the remainder. When a bank grants a loan, both the institution and the borrower consider the funds as assets, effectively doubling the initial amount in economic terms. This money is then reused, reinvested, and lent out repeatedly, generating a multiplier effect.

###Historical Origins of the Fractional Reserve System

The fractional reserve system originated around 1668 when the Swedish central bank became the first in the world. However, more rudimentary forms already existed earlier. The idea that deposits could be used to stimulate the economy through loans quickly gained popularity.

After Sweden took measures to formalize this practice, the fractional reserve system was established and spread rapidly. In the United States, two central banks were created, the first in 1791 and the second in 1816, but neither lasted. In 1913, the Federal Reserve Act created the central bank of the U.S., with the goals of stabilizing, maximizing, and supervising the economy in relation to prices, employment, and interest rates.

###Functioning of the fractional reserve system

When a customer deposits money into their bank account, the ownership of that money is transferred to the bank. In exchange, the bank offers customers a deposit account from which they can withdraw. However, the bank does not keep the total amount in the customer's account. A small percentage of the deposit is reserved (for fractional reserve), usually ranging between 3% and 10%, and the remainder is used to grant loans to other customers.

The multiplier effect of money can be illustrated through a practical example: when Client A deposits $50,000 in Bank 1, it reserves 10% ($5,000) and lends $45,000 to Client B, who deposits this amount in Bank 2. In turn, Bank 2 reserves 10% ($4,500) and lends $40,500 to Client C. This cycle continues through various banks and clients, so that an initial deposit of $50,000 can generate up to $234,280 in total currency available in the economy. This process demonstrates how the banking system effectively creates money through successive loans.

###System Risks and Vulnerabilities

A significant concern in the fractional reserve system is the risk of a bank run. If all the fund holders of a bank decided to withdraw their money simultaneously, the bank would likely fail due to its inability to meet its financial obligations.

The Great Depression in the United States is a notorious example of the catastrophe that can be caused by mass withdrawals. Currently, the reserves held by banks are one of the means to minimize the chances of a similar event. Some banks maintain reserves above the minimum required to better meet the demands of their clients and ensure access to funds in deposit accounts.

###Advantages and disadvantages of the system

The fractional reserve system offers significant benefits to banks, which reap most of the profits. Banking customers also benefit by earning interest on their deposit accounts. Governments often argue that this system encourages spending and promotes economic stability and growth.

However, many economists consider the fractional reserve system unsustainable and risky, especially considering that the current monetary system implemented by most countries is based on credit/debt and not on real money. Our economic system relies on people's trust in both banks and fiat money, established as legal tender by governments.

###Contrast with alternative monetary systems

Unlike the traditional fiat currency system, there are alternatives like criptomoedas, which operate fundamentally differently. These digital currencies are managed by distributed networks of nodes, with data protected by cryptographic proofs and recorded in a public and distributed ledger.

In this alternative context, there is no need for a central bank and there is no centralized responsible authority. Furthermore, the issuance of some cryptocurrencies is limited, meaning that no additional units will be generated after reaching the predefined maximum supply. Therefore, the concept of fractional reserve does not directly apply to the world of cryptocurrencies.