Money Multiplier Concept Explained Simply

The money multiplier concept is a fundamental idea in economics that helps us understand how banks create new money in the economy. It's based on the idea that banks can lend out a portion of their deposits, which then gets lent out again, creating a multiplier effect.

The money multiplier is calculated by dividing the money supply by the reserve requirement, which is the percentage of deposits that banks must keep in reserve. For example, if the reserve requirement is 10%, then the money multiplier would be 1/0.10, or 10.

In simple terms, the money multiplier concept works like a snowball rolling down a hill, gaining size and speed as it goes.

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The money multiplier concept is a fundamental idea in economics that explains how banks create money in the economy. It's a process that's been taught in undergraduate courses, but as we'll see, it doesn't always work as expected.

The textbook version of the money multiplier suggests that increasing central bank reserves gives commercial banks more room to lend, allowing them to multiply the money supply. However, this isn't always the case, as we'll explore further.

In the post-QE world, where reserves are in the trillions, there doesn't appear to be a boom in bank lending, which raises questions about the effectiveness of the money multiplier. This is a key issue that we'll delve into.

The money multiplier formula is simple: it's the required reserve ratio divided by one. This formula is based on the idea that banks must hold a fraction of deposits in reserve to meet potential withdrawal demands.

To calculate the money multiplier, you need to determine the number of deposits received by a bank, the number of loans extended, and the required reserve ratio. This involves some basic math, but it's essential to understanding how the money multiplier works.

The required reserve ratio is calculated by dividing the reserve amount by the total deposit amount. This ratio determines how much of each deposit a bank must hold in reserve.

The money multiplier formula is then calculated by dividing one by the required reserve ratio. This gives you the multiplier effect, which shows how much money is created through the fractional reserve banking system.

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The reserve ratio is a crucial concept in monetary policy. It's the percentage of deposits that commercial banks must hold in reserve and not lend out.

A higher reserve ratio acts like deflationary monetary policy, reducing bank lending and the money supply. This is because banks are required to hold more of their deposits in reserve, leaving less for lending.

The reserve ratio can be used to influence monetary policy. For example, if a central bank demands a higher reserve ratio, it can reduce the money supply and slow down economic growth.

Here's a list of key terms related to the reserve ratio:

The money multiplier is affected by the reserve ratio. A higher reserve ratio means a lower money multiplier, because banks are holding more of their deposits in reserve and lending less.

In theory, if a central bank demands a higher reserve ratio, it should reduce bank lending and therefore reduce the money supply.

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The money multiplier is a theoretical concept that can be predicted using the reserve ratio. If you have a reserve ratio of 5%, you can expect a money multiplier of 20, meaning you can effectively lend out £20 million with deposits of £1 million.

In reality, the money multiplier is often significantly smaller than the theoretical value due to various reasons. Import spending, taxes, savings, and currency drain ratio all contribute to this discrepancy.

The money multiplier can be calculated using the formula: Money Multiplier = 1 / Required Reserve Ratio. For example, if the required reserve ratio is 25%, the money multiplier would be 4. However, in practice, banks may not always lend out the maximum amount possible, and the actual money multiplier may be smaller than the theoretical value.

In the real world, the money multiplier is not as simple as the theoretical concept suggests. Import spending, taxes, and savings all play a significant role in reducing the actual money multiplier.

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The money multiplier is influenced by various factors, including import spending, taxes, and savings. If consumers buy imports, the money leaves the economy, reducing the multiplier. Similarly, a percentage of income is taken in taxes, and not all money is spent and circulated, a significant percentage is saved.

Banks may not want to lend, especially during a recession when firms and individuals are more likely to default. This can result in a higher reserve ratio, further reducing the money multiplier.

Currency drain ratio also affects the money multiplier. If consumers keep funds in cash, rather than depositing them in banks, the banks cannot lend more. This reduces the multiplier, as the money is not being circulated in the economy.

Bad loans can also reduce the money multiplier. If a bank lends out money, but the borrower defaults, the money is not deposited back into the banking system, reducing the multiplier.

A safety reserve ratio is also a factor. Banks may choose to keep a higher reserve ratio than the statutory requirement, reducing the money multiplier.

The money multiplier is not a fixed value, but rather a dynamic concept that is influenced by various factors in the real world.

Here's a list of factors that can reduce the money multiplier:

These factors can all contribute to a lower money multiplier in the real world, making it less effective than the theoretical concept suggests.

In practice, monetary policy is a bit more complex than the money multiplier theory suggests. Major central banks, such as the Federal Reserve, have not tried to control the monetary supply in recent decades, making the theory less relevant. This is partly because it's unclear how effective central banks would be in controlling the money supply, even if they wanted to.

The money multiplier is often calculated using a simple formula: if you have a reserve ratio of 5%, you can expect a money multiplier of 20. This means that if you have deposits of £1 million and a reserve ratio of 5%, you can effectively lend out £20 million.

However, in reality, the money multiplier is not as straightforward as this formula suggests. The ratio of M2 (a measure of private money) to M0 (the monetary base) is often referred to as the money multiplier, but it has been dropping in recent years.

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Here's a rough breakdown of how the money multiplier has changed over time:

In the aftermath of the 2008 recession, the Federal Reserve began paying interest on excess reserves, which reduced the incentive for banks to expand their balance sheets and lend more. This change is likely to explain the decrease in the money multiplier.

A higher reserve ratio demanded by a Central Bank can act like deflationary monetary policy, reducing bank lending and the money supply.

Banks can avoid reserve limitations by moving deposits off-shore, taking advantage of lower reserve requirements for Eurodollars.

The reserve ratio for Eurodollars has been 0 for U.S. banks since 1990, and this exemption has been a major driver of the growth of the off-shore dollar banking system in the 1960-70s.

Banks can reshuffle their liabilities to take advantage of lower reserve requirements for off-shore deposits, without changing their overall balance sheet size.

Booking deposits off-shore can reduce a bank's deposit liabilities, as seen in the example where a bank moved $10 million in deposits to its London branch, and then borrowed it back.

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In 2009-12, Central Banks pursued quantitative easing, which involves increasing the monetary base by buying bonds off banks, giving them greater cash reserves.

This should, in theory, increase the money multiplier and subsequently the overall money supply by a large amount. However, in practice, this didn't occur because banks were not keen to lend any extra money.

Banks were trying to improve their reserves following the credit crunch and their previous over-extension of loans.

Historical attempts to steer the supply chain have been a bit of a mixed bag. Central banks have tried to target a certain level or growth rate of money supply, but these strategies didn't quite work out.

In the late 1970s and 1980s, central banks were inspired by monetarist theory and the quantity theory of money, but these attempts were eventually abandoned.

The Federal Reserve's experiment with monetary base control in the US from 1979 to 1982 saw short-term interest rates become four times more volatile.

Quantitative Easing is a monetary policy tool used by Central Banks to increase the money supply. Central Banks pursued quantitative easing from 2009-12.

In theory, quantitative easing increases the money supply by a large amount due to the money multiplier. However, this didn't occur in practice because banks were not keen to lend any extra money.

Banks were trying to improve their reserves following the credit crunch and their previous over-extension of loans. This made them hesitant to lend even with increased cash reserves.

One zombie concept that's been lingering around is the idea of the money multiplier. As TB pointed out, the Fed no longer controls rates by adjusting the quantity of reserves.

The money multiplier never played a significant role in practice, as Jan noted. Reserve requirements never seemed to be a true constraint on credit creation by banks.

Here's a breakdown of how credit creation works: when a bank creates credit, there are two options - the deposit balance stays with the bank or the borrower transfers it to another bank. In either case, reserve requirements would put a cap on credit creation for the entire banking system.

The Fed Funds market can actually increase the effectiveness of reserve requirements. As Jan pointed out, pricing of Fed Funds becomes more expensive as the banking system approaches full capacity in terms of credit creation, making it unprofitable for banks to borrow to support credit creation.

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