Excess Reserves vs Money Multiplier
Excess Reserves and Money Multiplier are two Money & Monetary Policy concepts in AP Economics that students often mix up. Excess reserves are the funds a bank holds above its required reserves, which are available to lend out. The money multiplier is the maximum amount the money supply can increase for each dollar of new bank reserves. Here is how they compare side by side.
Banks create new money by lending excess reserves, which drives the money multiplier process. The central bank can change excess reserves through open market operations. When banks hold large excess reserves, the multiplier weakens.
It equals the reciprocal of the required reserve ratio, assuming banks lend all excess reserves and the public holds no extra cash. A lower reserve ratio gives a larger multiplier. Real-world leakages make the actual multiplier smaller.
Excess Reserves vs the Money Multiplier: A Dollar Balance and the Number You Multiply It By
| Excess Reserves | Money Multiplier | |
|---|---|---|
| Unit | Dollars on a balance sheet | A pure number, with no units at all |
| Whose figure it is | One bank's, readable straight off its T-account | The banking system's, never any single bank's |
| How you get it | Subtract required reserves from total reserves | Divide 1 by the required reserve ratio |
| What changes it | A new deposit, a new loan, a central bank purchase, or a change in the ratio | Only the required reserve ratio, plus behavior that lowers the realized value |
| Role in the arithmetic | The amount being multiplied | The factor doing the multiplying |
| What it limits | How much one bank can lend today | How far that loan can travel through later rounds of redeposit |
| The error it invites | Assuming one bank may lend a multiple of it | Assuming the maximum is what actually happens |
One bank lends its excess reserves, and the system lends the multiple
Set the required reserve ratio at an illustrative 25 percent, which makes the multiplier 1 divided by 0.25, or 4. A customer walks into Bank A and deposits $100 of currency. Deposits rise by $100 and so do reserves. Required reserves are 25 percent of $100, which is $25, so excess reserves are $75. Bank A can lend $75 and not a dollar more, because the check the borrower writes clears against Bank A's reserve account within days and a bank that lent $300 here would be unable to settle. The borrower spends the $75, it lands at Bank B, which holds $18.75 against it and lends $56.25, and the chain runs on. Add it all up and deposits across the system reach $400, since $100 divided by 0.25 is $400, and new loans total $300, which is the original $75 of excess reserves multiplied by 4. Two different sentences describe two different quantities. Bank A's lending capacity is a dollar balance sitting in its own reserve account. The $300 belongs to the system and arrives only because every later bank repeats the same small step with its own excess reserves. Compute both at /calculate/excess-reserves and /calculate/money-multiplier.
The multiplier gets applied to a different base depending on where the reserves came from
Hold the ratio at 25 percent and the multiplier at 4, and run three transactions that each involve $100. First, the cash deposit above. Currency held by the public falls by $100 while deposits rise by $100, so the money supply does not move at that instant. Excess reserves are $75, lending eventually adds $300 of new deposits, and the money supply ends up $300 higher. Second, the central bank buys a $100 security from a bank. No deposit is created, so required reserves do not change and the entire $100 is excess. Maximum deposit creation is $100 times 4, or $400, and the money supply rises by $400. Third, the central bank buys a $100 security from a household that deposits the check. Deposits and reserves both rise by $100, excess reserves are $75, further deposit creation is $300, and the money supply rises by $400 once the original deposit is counted. Same dollar figure, same multiplier, three different answers. The rule underneath is that excess reserves are the right base when the question asks how much new lending is possible, and total new reserves are the right base when it asks how far total deposits can rise.
Frequently asked questions
How do excess reserves and the money multiplier work together?
Excess reserves are the amount a bank is free to lend, and the money multiplier is how far that lending travels once the borrowed money is redeposited and lent again. Multiply the two and you get the maximum increase in loans and in newly created deposits for the banking system as a whole. With a 25 percent requirement the multiplier is 4, so $75 of excess reserves supports at most $300 of new loans. The word maximum carries weight, since cash the public keeps out of banks stops the chain early.
Can a single bank lend out its excess reserves times the multiplier?
No, a single bank can lend only its own excess reserves. The check the borrower writes clears against that bank's reserve account within days, so lending more would leave it unable to settle. The multiplied total appears across the banking system as later banks receive the resulting deposits and lend their own excess reserves in turn. Writing that one bank creates $300 out of $75 of excess reserves is a standard scoring error, because the other $225 is created by every other bank in the chain.
Does the money multiplier change when excess reserves change?
The money multiplier is set by the required reserve ratio, so a change in excess reserves alone leaves it exactly where it was. A bank that receives a new deposit has more excess reserves and the same multiplier. What does move it is a change in the required ratio, or a change in behavior: currency the public holds and reserves banks decide to keep idle both act like a higher ratio and pull the realized multiplier below 1 divided by the required ratio.
Live Money Market graph. Drag the curves, or open the full version.
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