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Deposit Multiplier vs. Money Multiplier: An Overview
The terms “deposit multiplier” and “money multiplier” are often confused and used interchangeably because they are very closely related concepts and the distinction between them can be difficult to grasp.
The deposit multiplier provides the basis for the money multiplier, but the money multiplier value is ultimately less, due to excess reserves, savings, and conversions to cash by consumers.
Key Takeaways
- The deposit multiplier, also known as the deposit expansion multiplier, is the basic money supply creation process that is determined by the fractional reserve banking system.
- The money multiplier reflects the amplified change in the money supply that ultimately results from the injection into the banking system of additional reserves.
- The deposit multiplier provides the basis for the money multiplier, but the money multiplier value is ultimately less, due to excess reserves, savings, and conversions to cash by consumers.
Deposit Multiplier
The deposit multiplier, also known as the deposit expansion multiplier, is the basic money supply creation process that is determined by the fractional reserve banking system. Banks create what is termed checkable deposits as they loan out their reserves.
The bank’s reserve requirement ratio determines how much money is available to loan out and therefore the amount of these created deposits. The deposit multiplier is then the ratio of the amount of the checkable deposits to the reserve amount. The deposit multiplier is the inverse of the reserve requirement ratio.
A deposit multiplier minimizes the risk of a bank not having enough cash on hand to satisfy day-to-day withdrawal requests from its customers. Its reserve requirement ratio also determines how much money it has to loan out or otherwise invest.
The deposit multiplier is sometimes expressed as the deposit multiplier ratio, which is the inverse of the required reserve ratio. For example, if the required reserve ratio is 20%, the deposit multiplier ratio is (1/0.20) = 5x.
Money Multiplier
The money multiplier reflects the amplified change in the money supply that ultimately results from the injection into the banking system of additional reserves.
However, the money multiplier differs from the more basic deposit multiplier because banks tend to keep excess reserves, and bank customers tend to convert some portion of checkable deposits to savings deposits or cash.
Money that banks are not required to hold in reserve is redirected into funding loans, and the borrowed funds end up in the deposit accounts of other clients. The total amount of new deposits or new money that is created can be captured using the money multiplier formula.
The money multiplier is important in macroeconomics because it determines the money supply, which affects interest rates. It’s also important in banking because it impacts monetary policy and the stability of the banking sector.
Note
During economic uncertainty, people tend to deposit more money in banks as a safe haven, increasing reserves.
Special Considerations
Banks commonly keep excess reserves beyond the minimum reserve requirements set by the Federal Reserve Bank. This reduces the number of checkable deposits and the total supply of money that is created.
Borrowers do not spend all of the money received from bank loans. If they did, and if banks loaned out every possible dollar beyond the minimum reserve requirements, then the deposit multiplier and the money multiplier would be close to exactly equivalent.
In reality, borrowers typically transfer some of the money to savings deposits. Like banks keeping excess reserves, this limits the created money supply and the resulting money multiplier figure. Similarly, conversions of checkable deposits to currency reduce the money multiplier by taking away some amount of deposits and reserves from the system.
What Does the Money Multiplier Describe?
The money multiplier describes how much the money supply can increase given the amount of reserves held by banks. When banks receive deposits from customers, they keep a portion as reserves and lend out the rest. The lent money is deposited in other banks, whereby the process is repeated, which effectively creates more money. The size of the multiplier depends on the reserve requirement set by a country’s central bank; lower requirements lead to a larger multiplier, and vice versa.
How Do You Calculate the Deposit Multiplier?
The deposit multiplier is calculated as the inverse of the reserve ratio set by a central bank. The formula is Deposit Multiplier = 1 / Reserve Ratio. For example, if the reserve ratio is 10% (0.1), the deposit multiplier would be 1 / 0.1 = 10. This means each dollar of reserves can support $10 of deposits in the banking system. It shows how much money banks can create through lending based on their reserves.
What Is the Difference Between M1 and M2 Money?
M1 and M2 money are both measures of the money supply. M1 is money in its most liquid form, such as cash, coins, and checking account deposits, which are available for spending right away. M2 money is M1 money plus small-denomination time deposits (less than $100,000) and retail money market mutual fund shares.
The Bottom Line
The money multiplier and the deposit multiplier are important concepts to know in order to understand the money supply in a fractional reserve banking system.
While the deposit multiplier reflects the theoretical creation of money based on reserve requirements, the money multiplier accounts for practical limitations, such as banks holding excess reserves and customers converting deposits into savings and cash.
These actions decrease the money supply expansion, which makes the money multiplier a better measure of economic impact; at least a more realistic one.