The money multiplier is a concept in macroeconomics that describes how an initial deposit into the banking system leads to a much larger increase in the total money supply (Mankiw, 2024). It illustrates the "magic" of fractional reserve banking, where banks keep only a small portion of deposits as reserves and lend out the rest.
How It Works: The Step-by-Step Process
Imagine someone deposits $1,000 into a bank, and the Federal Reserve has set a reserve requirement of 10%.
The First Loan: The bank keeps $100 (10%) in its vault and lends out the remaining $900.
The Redeposit: The borrower spends that $900 (e.g., to buy a laptop). The seller of the laptop then deposits that $900 into their own bank.
The Second Loan: The second bank keeps $90 (10%) and lends out $810.
The Cycle Continues: This process repeats over and over across the entire banking system.
The Formula
To calculate the maximum amount of money the banking system generates with each dollar of excess reserves, we use the money multiplier formula:
Where:
- m = The Money Multiplier
- R = The Reserve Requirement (expressed as a decimal)
If the reserve requirement is 10% (0.10), the multiplier is:
This means a $1,000 deposit could theoretically create $10,000 in total money supply (1,000 x 10).
Key Factors That Limit the Multiplier
In the real world, the money supply rarely reaches its theoretical maximum because of two main "leakages."
Excess Reserves: Banks might choose to hold onto more money than the law requires (especially during economic uncertainty) rather than lending it all out.
Currency Drains: If people decide to hold onto physical cash (putting it under a mattress) rather than depositing it back into a bank, the cycle stops.
Central banks use this principle to control the economy. By raising the reserve requirement, they "shrink" the multiplier to fight inflation. By lowering it, they "expand" the multiplier to encourage lending and jumpstart economic growth.
Final Tip
The money multiplier shows how an initial deposit can lead to a larger increase in the money supply through repeated lending and redepositing. The theoretical multiplier assumes banks lend all excess reserves and that all money remains in the banking system. In reality, excess reserves and currency held by the public can reduce the actual increase in the money supply.
Mankiw, N. G. (2024). Principles of Economics. Cengage Learning.
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