After this process has been repeated as many times as possible, that $1000 you originally deposited in your bank can actually be turned into as much as $10,000 in the overall money supply. You can calculate the $10,000 by dividing your initial $1,000 deposit by 10%.

In this way, the total money supply in the economy increases when banks make loans. But, when the money supply increases, the consequence is inflation. Fractional reserve banking leads to inflation.

What If There's a Run on the Banks?

Because banks operate on slim reserve requirements, they would have an immediate and serious problem if their customers were to all demand their money back at the same time. This is what led to the thousands of bank failures during the Great Depression. In response to this crisis, the U.S. government created the FDIC in 1933, which insures the deposits in banks that purchase FDIC insurance.

The Birth of Fractional Reserve Banking

So how did fractional reserve banking come to be? To get the answer, we need to go all the way back to the 16th century and the time of the goldsmiths.

Goldsmiths were the first bankers. Goldsmiths would store a person's gold and keep it safe for a fee. They would provide the owner of the stored gold a receipt to indicate the amount of gold they had stored. The owner of the gold could redeem his receipt for gold at any time. Eventually the receipts themselves were used as money rather than the gold itself.