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What Is the Deposit Multiplier?
Let me explain the deposit multiplier directly: it's the maximum amount of money a bank can create for each unit of money it holds in reserves. This involves the percentage of deposits that the bank can loan out, which is typically set by the Federal Reserve's reserve requirement.
You should know that the deposit multiplier is essential for maintaining an economy's basic money supply. It's part of the fractional reserve banking system, which banks use in most countries around the world.
Key Takeaways
Here's what you need to grasp: the deposit multiplier represents the maximum amount of money a bank can create as checkable deposits for each unit of reserves. This is crucial for the economy's money supply and is a core element of fractional reserve banking. While the Federal Reserve sets minimum reserves, banks might choose higher ones themselves. Remember, it's not the same as the money multiplier, which shows changes in the nation's money supply from actual loan usage.
Understanding the Deposit Multiplier
I want to make this clear: the deposit multiplier, sometimes called the deposit expansion multiplier or simple deposit multiplier, ties into the portion of a bank's deposits that can be lent to borrowers. When banks lend, they inject money into the nation's supply and boost economic activity. Essentially, it shows how banks can multiply deposits through lending.
Central banks like the Federal Reserve set minimum reserves that banks must hold. These required reserves ensure banks have enough cash for depositor withdrawals. The Fed even pays a bit of interest on these reserves, which can be kept at the bank or a Federal Reserve branch.
The deposit multiplier relates to the reserve percentage, giving you an idea of how much money banks could create from what they lend after setting aside reserves.
Deposit Multiplier Calculation
Calculating the deposit multiplier is straightforward: it's the inverse of the required reserve percentage. For example, if the reserve requirement is 20%, the multiplier is 1 divided by 0.20, which equals 5.
That means for every $1 in reserves, a bank can theoretically increase deposits and the money supply by $5 through lending. The amount a bank can lend from checkable deposits—those allowing checks or other instruments—depends on the Fed's requirement. In fractional reserve banking, with a 20% requirement, the bank lends out 80% of deposits.
Deposit Multiplier vs. Money Multiplier
Don't confuse the deposit multiplier with the money multiplier—they're related but different. The money multiplier shows the change in a nation's money supply from loans beyond reserves, representing the maximum potential from all bank lending.
The deposit multiplier forms the basis for the money multiplier, but the latter is smaller due to excess reserves, savings, and cash conversions by consumers. Banks might hold extra reserves to limit checkable deposits, reducing new money injected into the supply.
What Is Fractional Reserve Banking?
Fractional reserve banking is a system where banks hold a portion of deposits in reserve to handle daily operations and meet withdrawal requests. The rest can be loaned out, continually adding to the money supply and supporting the economy. The Fed influences this by adjusting reserve requirements to control the money supply.
How Does the Deposit Multiplier Relate to the Money Supply?
The deposit multiplier indicates how much a bank's lending can add to the money supply. Banks multiply deposits nationwide by lending to borrowers who then deposit funds elsewhere. It shows money creation per unit in reserve. A higher reserve requirement means a smaller multiplier and less deposit growth from lending.
How Do You Calculate the Deposit Multiplier?
To calculate it, take the Fed's reserve requirement and divide 1 by that figure. For an 18% requirement, it's 1 divided by 0.18, equaling about 5.55. So, for every $1 in reserves, $5.55 could be added to the money supply. Lower requirements allow more creation since more money is available for lending.
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