"Briefly explain ‘Fractional Reserve Banking’ and discuss how shifts in bank reserve ratios can be used as a fiscal policy tool to stimulate/dampen economic activity."
Fractional reserve banking is a banking system in which only a fraction of bank deposits are backed by actual cash-on-hand and are available for withdrawal. This is done to expand the economy by freeing up capital that can be loaned out to other parties. Most countries operate under this type of system. It is the primary mode of operation of nearly all retail banks in the modern world.The primary reason for reserve requirements is to maintain the stability of the banking system and to avoid bank panics and other problems created when banks run short of reserves.
Fractional-reserve banking makes it possible for banks to function as profit-seeking financial intermediaries (matching up lenders and borrowers) while ensuring the safety and liquidity of deposits, especially checkable deposits that are part of the economy's money supply.
If the economy is mired in a recession, then the appropriate fiscal policy is to increase spending or reduce taxes, using expansionary fiscal policy to encourage people to borrow to invest and spend. in the near term it has been sufficient to keep the stock averages rising and the harvest of speculative winnings flowing to the top 1 percent.
During periods of high inflation, the opposite actions are needed, to decrease spending or raise taxes, borrowers will once more have to reduce expenditure in other areas of economic activity. The government first tries to stimulate the economy and spend money into the markets directly without individuals needing to borrow and spend, thereby "inflating" its way out of economic crisis by causing asset prices to rise and bank balance sheets to appear solvent. It currently does this principally by borrowing newly created money from the central bank and then spending this new money on projects that the private sector is not already engaged in
in order to create new jobs and boost the economy, interest rates have to be reduced. That has happened. People are encouraged to borrow to invest and spend. That has happened. As the continuing flow of new money finds its way into the economy, inflation will follow and up will go interest charges again to reduce the level of borrowing. In order to pay the increasing levels of interest, borrowers will once more have to reduce expenditure in other areas of economic activity. The cycle will continue, but the next time, as before, we will all start deeper in debt and with a burden harder to carry.
Many U.S. banks were forced to shut down during the Great Depression because so many people attempted to withdraw assets at the same time. Today there are many safeguards in place to prevent such an instance from occurring again, but the fractional-reserve banking system remains in place.
Fiscal policy makes use of the federal government's powers of spending and taxation to stabilize the business cycle. This policy is under the control of legislative and executive branches of the federal government charged with collecting taxes and spending available revenues.
The Fed can further adjust the proportion of reserves that banks must keep to back outstanding deposits (the reserve ratio). Higher and lower rates affect the deposit multiplierand the amount of deposits banks can create with a given amount of reserves. If the Fed lowers reserve requirements, then banks can use existing reserves to make more loans and thus increase the money supply. If the Fed raises reserve requirements, then banks can use existing reserves to fewer more loans and thus decrease the money supply. This tool is seldom used as a means of controlling the money supply.
Monetary policy is controlling of the quantity of money in circulation for the expressed purpose of stabilizing the business cycle and reducing the problems of unemployment and inflation. In days gone by,