AP® Macroeconomics · Unit 4 · Topic 4.4
Fractional Reserve Banking and the Balance Sheet
Banks keep only a fraction of deposits on hand as reserves and lend out the rest, which is legal and shows up clearly on a bank's balance sheet.
A bank's balance sheet, called a T-account, has assets on one side and liabilities on the other. Deposits are a liability: the bank owes that money back to the depositor. Reserves and loans are assets: things the bank holds or is owed. When you deposit 1000 dollars in cash, the bank's liabilities rise by 1000 (it owes you that money) and its assets rise by 1000, first entirely as reserves. The reserve requirement, set as a percentage, tells the bank the minimum fraction of deposits it must keep on hand rather than lend out. Everything above that minimum is excess reserves, and that is the part the bank is free to lend.
This matters because lending is how a bank earns money, through interest, and it is also how the banking system creates new money. A depositor can still demand their full balance anytime, but under normal conditions only a small share of depositors ask for cash on the same day, so the bank keeps just enough reserves to cover typical withdrawals and lends the rest to borrowers who pay interest. The bank is not stealing or hiding your money; it is operating exactly as fractional reserve banking is designed to work.
This setup sets up the money multiplier: each loan becomes a new deposit somewhere else, which then supports further loans, expanding the money supply. It also connects to the money market, where the central bank influences the nominal interest rate partly by changing reserve conditions, and to loanable funds, where those same deposits and loans determine the real interest rate that balances saving and investment.
Key terms
- T-account
- A simple two-column balance sheet showing a bank's assets on one side and liabilities on the other.
- Required reserve ratio
- The minimum fraction of deposits a bank must hold as reserves rather than lend out.
- Required reserves
- Deposits multiplied by the required reserve ratio, the minimum reserves a bank must keep.
- Excess reserves
- Total reserves held minus required reserves, the amount a bank is free to lend.
- Bank run
- A situation where many depositors withdraw funds at once, which the bank cannot fully cover since most funds are loaned out.
Watch it explained
- How it worksWalk me through a bank's T-account when someone deposits 1000 dollars in cash.
- Worked exampleFind required and excess reserves for a bank holding 5000 in deposits at a 10 percent reserve ratio.
- Common mistakeWhy doesn't a bank run mean the bank was doing something dishonest?
- Going furtherWhat happens on the balance sheet when that bank then makes a 4500 dollar loan?
Check yourself
End of topic.