Fractional-reserve banking means that the amount of the commodity in reserve, that the money is based on, amounts to only a fraction of the money in circulation. For example there could be $100 worth of gold in bank's reserves and $500 in circulation of which $400 would have been created by the bank as a loan. The bank would be practising 1/5 fractional-reserve banking.
To understand fractional reserve banking, it's necessary to understand where bank notes originally came from. In the old times people used to deposit their gold, silver and other commodity valuables at gold smiths, who are also called the money changers. In a return, depositers received a note of their deposit. Over the time these notes started to be used directly in trading so trade participants didn't anymore claim back their gold to perform the trade. Thus paper money was born.
Now as the notes were used directly in trading, the money changers soon realized that people would never all at the same time come to withdrawn their deposits. Thus money changers started lending bank notes at interest, but without having equivalent reserves to back it all up.
For example there is $20 dollars worth of gold in a bank's reserves and so there are people whose notes add up to $20 worth of gold. Now bank prints $10 worth of bills and loans them at interest. Now the bank is doing 2/3 reserve banking. If over time the people who had loaned the money would not be successful in business, they would get in debt to the bank. Thus the bank would have gained profit from nothing.
In the modern world foundations such the World Bank, European Central Bank and Federal Reserve System, and all the banks operating under them, have the sole right to print new money and thus perform fractional-reserve banking.
Since many are unaware of the existence of this banking practice and because of the possible controversy in the process of banks giving debt loan from fractional-reserve banking-created money, some people call it the 'fractional-reserve banking system scam'.
The process of fractional-reserve banking naturally causes inflation. To the different price indexes the effect comes with a delay. Extensive use of fractional-reserve banking might result in hyperinflation.
Many of the United States of America presidents and founding fathers fought against private banks having the right to perform fracitonal-reserve banking. See Thomas Jefferson, James Madison, Andrew Jackson, Abraham Lincoln. Also John F. Kennedy prior to his death signed a Presidential decree to strip Federal Reserve Bank of its right to loan money at interest to the United States Federal Government.
The opposite of fractional reserve banking is full reserve banking.
