How does fractional reserve banking create money?

Fractional reserves by themselves do not create money. However, fractional reserves enable banks to expand the money supply through additional lending. The process of money supply expansion occurs when banks continually find new borrowers for additional funds deposited by other borrowers.

Let's use an example where banks have a 10% reserve requirement. This means that, for every deposit of $1, banks must hold $0.10 in reserve, and they can lend $0.90.

Bank A receives a deposit of $100. Bank A keeps $10 in reserve and lends $90 to Borrower A.

Borrower A deposits $90 in Bank B. Bank B keeps $9 in reserve and lends $81 to Borrower B.

Borrower b deposits $81 in Bank C. Bank C keeps $8 (rounding) in reserve and lends $73 (rounding) to Borrower C.

If this process continues indefinitely, then total lending, based on the initial deposit of $100, becomes $100 / 10% or $1,000. The multiplier is 1/(reserve requirement).

The central bank uses this multiplier to influence money supply by adding to (or detracting from) bank reserves. If the Fed wants to create additional money supply to help stimulate the economy, for example, it will buy government bonds (which are existing government debt) from banks. This converts assets on bank balance sheets to cash -- effectively increasing bank reserves. The increase in reserves has the same multiplier effect as a straight deposit would have.

Conversely, if the Fed wants to decrease the money supply, it will sell bonds to banks. This will convert cash assets in banks to loan assets, effectively lowering their reserves. This will cause bank lending to contract.