Money Multiplier: Definition & Formula
Banks actually create money by lending money. In this lesson, you’ll learn about the money multiplier, including what it is, its formula, and how to use it. You’ll also have a chance to take a short quiz after the lesson.
Definition of Money Multiplier
The money multiplier is the amount of money that banks generate with each dollar of reserves. Reserves is the amount of deposits that the Federal Reserve requires banks to hold and not lend. Banking reserves is the ratio of reserves to the total amount of deposits.
The money multiplier is the ratio of deposits to reserves in the banking system. Why is this important? Let’s take a look at an example to illustrate the power of banks to literally create money out of thin air.
Imagine that you are president of a large bank. The Fed requires that you hold 10% of your deposits in reserves, a reserve ratio of 1/10. This means that for every $1.00 of deposits, you can only lend out $0.90. The total value of your bank’s deposits is $100,000,000. You want to maximize your bank’s profits, so you loan out all of the $90,000,000. All of sudden, you’ve just increased the supply of money from $100,000,000 to $190,000,000!
Here’s how you did it. Your depositors still have $100,000,000 with you, but only on paper. They can come in any time and get their money. However, since not everyone wants, or needs, their money at the same time, your reserves of $10,000,000 will cover the normal demand for withdrawals.
At the same time, you have distributed $90,000,000 in loan funds to your borrowers – that’s real money going out the bank’s door. Your borrowers will spend that money on houses, cars, factories, and machinery, among countless other purchases. The sellers who receive the loaned money in exchange for their goods or services will deposit their revenue in banks. And of course, the banks will turn around and loan out another 90% of that $90,000,000, and the cycle will start over again.
So, what does this have to do with the money multiplier? The money multiplier will tell you how fast the money supply from the bank lending will grow. The higher the reserve ratio is, the less deposits will be available for lending, resulting in a smaller money multiplier. Now, let’s see how to calculate the money multiplier.
Money Multiplier Formula
The money multiplier is the reciprocal of the reserve ratio:
Money multiplier = 1 / R, where R is the reserve ratio
Imagine you are still the president of that bank, and you get notice from the Fed that it is loosening its minimum reserve requirements from 10% to 5%. What is the new money multiplier?
Money multiplier = 1 / R, where R is the reserve ratio
You can get the ratio by converting the percentage into a fraction by simply dividing it by 100 and then simplifying the fraction:
5 / 100 = 1/20
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