Definition
The money multiplier is a factor that quantifies the amount of money that banks can create in the banking system based on the reserves they hold. It represents the maximum potential increase in the money supply due to an initial deposit, given the reserve requirement set by the central bank.
Formula
The money multiplier (mmm) is inversely related to the reserve requirement ratio (r):
m=1/r
Where:
- m is the money multiplier.
- r is the reserve requirement ratio (the fraction of deposits that banks are required to hold as reserves).
How It Works
When a bank receives a deposit, it keeps a fraction of the deposit as reserves and lends out the remainder. This lending creates new deposits in the banking system, which in turn create more loans, leading to a multiplied effect on the overall money supply.
Example of Money Multiplier in Action
Initial Deposit
Let’s consider an initial deposit of $1,000 into Bank A, with a reserve requirement ratio of 10% (0.10).
- Bank A’s Actions:
- Bank A keeps 10% of $1,000 as reserves, which is $100.
- Bank A lends out the remaining 90%, which is $900.
- Second Deposit:
- The $900 loan is deposited into Bank B.
- Bank B’s Actions:
- Bank B keeps 10% of $900 as reserves, which is $90.
- Bank B lends out the remaining 90%, which is $810.
- Third Deposit:
- The $810 loan is deposited into Bank C.
- Bank C’s Actions:
- Bank C keeps 10% of $810 as reserves, which is $81.
- Bank C lends out the remaining 90%, which is $729.
This process continues, with each bank keeping 10% of the deposit as reserves and lending out the remaining amount.
Calculating the Total Money Supply
The total increase in the money supply (ΔM) due to the initial deposit can be calculated using the money multiplier:
ΔM=Initial Deposit×m
Given:
- Initial deposit = $1,000
- Reserve requirement ratio (r) = 10% (0.10)
- Money multiplier (mmm) = 1/r=1/0.10=10
So, the total increase in the money supply is:
ΔM=1,000×10=10,000
Thus, an initial deposit of $1,000 can potentially increase the total money supply by $10,000 through the money multiplier effect.
Detailed Breakdown of Each Step
Step 1: Initial Deposit in Bank A
- Deposit: $1,000
- Reserves (10%): $100
- Loanable Funds (90%): $900
Step 2: Loan in Bank A Deposited in Bank B
- Deposit: $900
- Reserves (10%): $90
- Loanable Funds (90%): $810
Step 3: Loan in Bank B Deposited in Bank C
- Deposit: $810
- Reserves (10%): $81
- Loanable Funds (90%): $729
This process continues, with each subsequent bank receiving deposits and making loans, keeping a fraction of the deposits as reserves and lending out the remainder.
Limitations of the Money Multiplier
While the money multiplier provides a theoretical maximum for money creation, several factors can limit its practical application:
- Excess Reserves:
- Banks may choose to hold reserves above the required minimum, reducing the amount available for loans.
- Demand for Loans:
- If demand for loans is low, banks will not be able to lend out all available funds, limiting the money multiplier effect.
- Regulatory Constraints:
- Regulatory requirements and prudential norms may restrict the amount of lending.
- Cash Holdings:
- If the public prefers to hold cash rather than deposits, the money multiplier effect will be reduced.
Conclusion
The money multiplier is a key concept in understanding how banks can create money through the fractional reserve banking system. It shows how an initial deposit can lead to a multiplied increase in the total money supply, depending on the reserve requirement ratio. While the theoretical money multiplier provides insights into the potential for money creation, practical limitations such as excess reserves, loan demand, and regulatory constraints can affect the actual money supply expansion. Understanding the money multiplier helps in grasping the dynamics of money creation and the role of banks in the broader economy
