[Scarblac]

That's not how fractional reserve banking works. It works by getting money in deposits and then loaning out most of it, keeping only a fraction in case some depositor wants his money back.

The reason that that act creates money is that the money in the deposits can still be requested by depositors at any moment -- it's still fully liquid, and thus the depositors still have their money. But so does whoever borrowed money.

The effect is compounded a lot by the fact that the borrowed money will also end up in some bank account almost certainly, and be almost entirely lent out again, and so on.

[slv77]

Nit pick...

Banks create the money when they create the loan. Assume the simple case where the buyer of the house has an account at the same bank as the seller. The bank puts an credit on its books for the loan and a debit on its books for the sellers account.

The money in the sellers account is newly created money. They didn't have to ring up the Federal Reserve or get permission. They got the permission when they got their banking license.

Let's assume the buyer now wants to move that money to another bank. He transfers his deposit from bank A to bank B. Bank B now has excess funds on its books and deposits it at the central bank. Bank A now has a deficit and goes to the central bank for a loan. The central bank loans money on deposit from Bank B to Bank A and everything balances.

Now let's say he wants to convert it to cash. He goes to Bank B and withdraws his deposit in cash. Bank B then goes to the central bank and requests the funds. The central bank then gives a loan to the central government for the amount of cash that it needs. Then it takes that loan to the central government which issues cash in the value of the loan. Bank B then exchanges its deposit at the central bank for cash and gives it to the customer. The central bank now has a deposit from the central government in the amount of the loan from Bank A and so everything, again, balances.

The only restriction that banks have on creating money these days is the ratio of equity against the entire size of their balance sheet.

[Scarblac]

Bank A doesn't need to get a loan yet after the money is moved away to bank B, after all they kept a percentage of the original deposit, so they have sufficient reserves. Right?

[slv77]

Reserves are deposits with the central bank or cash sitting in the vault. Reserves are created when the central bank makes a direct loan which is typically to the central government or through the discount window (where they buy a loan at a discount from a member bank).

Reserve requirements essentially mean that each bank has to have some amount of deposits at the central bank that is proportional to the size of it's balance sheet. In theory that limits the total amount of money to a multiple of the amount of base money which is controlled by the central bank.

In practice central banks have been moving away from reserve requirements as a way to influence monetary policy and some countries have eliminated reserve requirements entirely. In the US cash and reserves doesn't pay interest and so acts as a tax on the banking system. When market rates are high like they were in the 70's and 80's this tax can be significant and at some points lead to banks leaving the Federal Reserve System all together and the creation of non-bank competitors for deposits such as money market funds.

Today most banks balance sheets are limited by regulatory capital ratios rather than reserve requirements.

A history of reserve requirements can be found here that lays it out in detail. I highly recommend it if you find yourself unable to sleep on a plane. Skip to the end if you are interest in current history:

https://www.federalreserve.gov/monetarypolicy/0693lead.pdf

Unfortunately there is a lot of bad information (and conspiracy theories) about fractional reserve banking on the internet which in many cases is outright wrong and in the best cases no longer relevant.