The Money Multiplier refers to how an initial deposit can lead to a bigger final increase in the total money supply.
For example, if the commercial banks gain deposits of £1 million and this leads to a final money supply of £10 million. The money multiplier is 10.
The money multiplier is a key element of the fractional banking system.
- There is an initial increase in bank deposits (monetary base)
- The bank holds a fraction of this deposit in reserves and then lends out the rest.
- This bank loan will, in turn, be re-deposited in banks allowing a further increase in bank lending and a further increase in the money supply.
The Reserve Ratio
The reserve ratio is the % of deposits that banks keep in liquid reserves.
For example 10% or 20%
Formula for money multiplier
In theory, we can predict the size of the money multiplier by knowing the reserve ratio.
- If you had a reserve ratio of 5%. You would expect a money multiplier of 1/0.05 = 20
- This is because if you have deposits of £1 million and a reserve ratio of 5%. You can effectively lend out £20 million.
Example of money multiplier
- Suppose banks keep a reserve ratio of 10%. (0.1)
- Therefore, if someone deposits $100, the bank will keep $10 as reserves and lend out $90.
- However, because $90 has been lent out – other banks will see future deposits of $90.
- Therefore, the process of lending out deposits can start again.
Note: This example stops at stage 10. In theory, the process can continue for a long time until deposits are fractionally very small.
- If allowed to repeat for an infinite number of times, the final total deposits would be $1,000
- Money multiplier = 1/0.1 = 10.
- Final increase in money supply = 10 x $100 = $1,000
Using the Reserve ratio to influence monetary policy
In theory, if a Central Bank demands a higher reserve ratio – it should have the effect of acting like deflationary monetary policy. A higher reserve ratio should reduce bank lending and therefore reduce the money supply.
Money Multiplier in the real world
In a simple theory of the money multiplier, it is assumed that if the bank lends $90 – all of this will return. However, in the real world, there are many reasons why the actual money multiplier is significantly smaller than the theoretically possible money multiplier.
- Import spending. If consumers buy imports the money leaves the economy
- Taxes. A percentage of income will be taken in taxes.
- Savings. Not all money is spent and circulated, a significant percentage will be saved
- Currency Drain Ratio. This is the % of banknotes that individual consumers keep in cash, rather than depositing in banks. If consumers deposited all their cash in banks, there would be a bigger money multiplier. But, if people keep funds in cash then the banks cannot lend more
- Bad loans. A bank may lend out $90 but the company goes bankrupt and so this is never deposited bank into the banking system.
- Safety reserve ratio. This is the % of deposits a bank may like to keep above the statutory reserve ratio. i.e. the required reserve ratio may be 5%, but banks may like to keep 5.2%.
- It might not be possible to lend more money out. Just because banks could lend 95% of their deposits doesn’t mean they can, even if they wanted to. In a recession, people may not want to borrow, but they prefer to save.
- Banks may not want to lend Also, at various times, the banks may not want to lend, e.g. during a recession they feel firms and individuals more likely to default. Therefore, the banks end up with a higher reserve ratio.
Therefore, due to these factors, the reserve ratio and money multiplier are theoretical.
Loan first multiplier
The money multiplier model suggests banks wait for deposit and then lend out a fraction. However, in the real world, banks may take it upon themselves to issue a loan, and then seek out reserves from other financial institutions/Central Bank or private individuals.
For example, in the credit bubble of 2000-2007, many banks were lending mortgages by borrowing on short-term money markets. They were lending money that wasn’t related to saving deposit accounts.
Money multiplier and quantitative easing
In 2009-12 Central Banks pursued quantitative easing. This involves increasing the monetary base. – Buying bonds off banks gave them greater cash reserves. In theory, this increase in the money multiplier should increase the overall money supply by a large amount due to the money multiplier
Also, banks were trying to improve their reserves following the credit crunch and their previous over-extension of loans.