Fractional reserve banking and the value of someone else's currency Suppose there are two countries: $A$ and $B$. $A$ is a large, stable, democratic country with its own currency, the dollar. $B$ does not have its own currency. All prices and financial transactions in $B$ use the dollar and $B$'s citizens have a positive quantity of dollars that they hold domestically.

Country $B$ has a monopoly retail bank that is required to hold 5% of the value of its deposits as reserves in the safe keeping of an independent central bank, also located and controlled within $B$.

My question is: does this suffice for the bank in country $B$ to practice fractional reserve banking? If so, am I correct in thinking that the bank in country $B$ is exerting an externality on the people of country $A$ by devaluing their currency every time it creates a new loan? Is there anything that $A$ can do to prevent this?
When the retail bank in country B multiplies the money supply, it does so by creating an asset (money owed by the borrowers) and a liability (the obligation to honor the loan it gave to the borrowers) on its books, and an asset (money to spend) and a liability (the loan to pay back) on the books of each of the borrowers. 

Now, if these borrowers are all spending their money amongst each other, this probably isn't going to be a problem. It by no means affects inflation in country A, because there's no additional demand on country A's resources. 

But lets say instead all of the borrowers then go to use this money to import some goods from country A. This will be, on the face of it, inflationary. Suddenly you have all this extra demand, for no additional supply. 

One of two things happens:


The borrowers say to country A's exporter, 'I would like to buy some widgets, get the cash from my bank' and exporter (or rather, the exporter's bank, who is based in country A) says to the bank 'Cash please!'. Country B's bank doesn't have the cash to honor every loan they've made, so they're unable to honor the payments and the loan they gave the borrowers is essentially worthless. The exporter doesn't send the goods. 
The exporter in country A's bank is ok with the promise of payment from the bank in country B. Afterall - there are also exporters in country B selling goods to people in country A, and this will balance out the loan. 


In this second scenario - the there is also an increase in supply because country B is also exporting to country A, so it's not necessarily inflationary. 

Bottom line: The inflationary effect of multiplying the money supply will be tempered by the bank's ability to honor the loans. A bank can make all the on paper loans it wants, but unless it's able to actually honor them, they are meaningless. In our modern banking system, there's a high degree of trust which means when a bank lends us money, and we see that money in our bank account,  we assume that that money is actually going to be able to buy us goods.