Money Multiplier
What is Money Multiplier?
The money multiplier is the maximum amount the money supply can increase for each dollar of new bank reserves.
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.
Money Multiplier: a worked example
Suppose the required reserve ratio is 20 percent, so the money multiplier is 1 ÷ 0.20 = 5. A customer deposits $1,000 in cash: the bank must hold $200 as required reserves and has $800 in excess reserves to lend. As that $800 is lent, spent, redeposited and lent again through the banking system, it can create up to $800 × 5 = $4,000 in new demand deposits, bringing total deposits traceable to this one $1,000 to $5,000.
The mistake students make with money multiplier
Students multiply the full $1,000 deposit by the multiplier of 5 and report $5,000 of newly created money. Only $4,000 of it is new, because the original $1,000 was already part of the money supply as currency and merely changed form when it moved into a checking account. Multiply the multiplier by excess reserves, not by the whole deposit, to get the money created.
Money Multiplier questions
How do you calculate the money multiplier?
The money multiplier equals 1 divided by the required reserve ratio, so a 10 percent reserve requirement gives a multiplier of 1 ÷ 0.10 = 10. Multiplying that multiplier by a bank's excess reserves gives the maximum amount of new money the banking system can create.
What is the money multiplier if the reserve requirement is 25 percent?
A required reserve ratio of 25 percent gives a money multiplier of 1 ÷ 0.25 = 4, so $1,000 of excess reserves can support up to $4,000 of new money. A higher reserve requirement always produces a smaller multiplier and less money creation.
Why is the actual money multiplier smaller than 1 divided by the reserve ratio?
The actual money multiplier is smaller than 1 divided by the reserve ratio because of leakages: households keep some cash outside the banking system, and banks often hold excess reserves instead of lending every available dollar. The formula gives the maximum possible expansion, not what really happens.
Formula / Example
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Common comparisons
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