The theory goes that a bank takes $1000 in deposits, keeps 10% to fulfill the RRR, and loans out the remaining $900.

The loan increases the money supply in the system by $900, since the initial depositor still has $1000, and the loanee has $900.

The bank, by originating a loan, has created $900 in new money. 

Now, the $900 is spent by the loanee and deposited into a second bank. This second bank keeps 10% of the $900, which is $90, and loans out the remaining $810.

In originating this second loan, the second bank creates another $810, thereby increasing money supply again.

This goes on until the theoretical maximum of the money multiplier, defined as 1/RRR, in money is created. 

The theoretical process described above is known as Fractional Reserve Banking; fractional because a fraction is kept in reserve and the remainder loaned out. As such banks are susceptible to runs since they never hold the full amount of Reserves that its customers have deposited.

However, while the RRR is an important part of how Fractional Reserve Banking works, it isn’t the foundation upon which the model is built upon.

Instead, the foundation of Fractional Reserve Banking is the underlying assumption that Reserves are loaned out; because if this assumption were proved to be false, then money simply will not be created in the banking system and wider economy.

And…unfortunately for the multitude of people who believe that money is created via Fractional Reserve Banking, Reserves are not loaned out.

The next instalments in this series will deal with the many questions, ramifications, and explanations that the above statement will have elicited.

To be continued…