Overview of the Deposit Multiplier
The deposit multiplier represents the maximum amount of money that a bank can generate for each unit of money it holds in reserves. This system allows banks to loan out a specific percentage of deposited funds, amplifying the economy’s basic money supply, all within the structure of a fractional reserve banking system. Typically, the reserve requirements for these calculations are designated by central banks, like the Federal Reserve in the United States.
Key Takeaways
- The deposit multiplier illustrates the maximum amount of checkable deposits a bank can create from its reserves.
- It’s integral to sustaining an economy’s basic money supply.
- It operates within the common fractional reserve banking system used globally.
- Even though reserve minimums are set by central banks, individual banks can opt for higher reserves.
- The deposit multiplier differs from the money multiplier, which depicts the change in a nation’s money supply via loans.
Delving Into the Deposit Multiplier
Commonly referred to as the deposit expansion multiplier or simple deposit multiplier, this concept indicates the portion of a bank’s deposits available for lending. This lending mechanism injects funds into the nation’s money supply, thus promoting economic activity and revealing how banks can effectively multiply deposits.
Central banks set minimum reserve requirements, compelling banks to maintain reserves aside from loans to ensure liquidity for withdrawal requests. A small interest is also provided on these reserves, further stabilizing the system.
How to Calculate the Deposit Multiplier
Represented as the inverse percentage of required reserves, if the reserve requirement is 20%, the deposit multiplier emerges as follows:
Deposit multiplier = 1/.20
Deposit multiplier = 5
Thus, for every dollar in reserves, a bank can theoretically increase deposits, and hence the money supply, by five dollars. With fractional reserve banking, if the requirement is 20%, the bank can lend 80% of deposited funds.
Differentiating Deposit Multiplier from Money Multiplier
Often confused, the deposit multiplier and money multiplier are distinct. The money multiplier captures the total change in national money supply per additional reserve dollar. While related, actual values usually fall short of deposit multiplier predictions due to additional reserves, savings habits, and cash conversion by consumers.
Banks might hold reserves above mandated levels, thus limiting the number of new deposits and slowing money supply injection.
What Is Fractional Reserve Banking?
This banking method holds a portion of all deposits in reserve to meet daily operational demands and withdrawal requests. The remaining funds are loaned, adding to national money supply and boosting economic growth. By adjusting reserve requirements, central banks can influence total money supply.
How Does the Deposit Multiplier Affect the Money Supply?
The deposit multiplier gauges how lending activities of banks amplify money supply. When banks lend to borrowers who redeposit funds, deposits multiply across the system. Higher reserve requirements decrease the deposit multiplier, thus reducing deposit increases through lending.
Calculating the Deposit Multiplier in Practice
Utilize the reserve requirement from the central bank (e.g., Federal Reserve). Divide this value into 1 to ascertain potential increase in money supply. Example: with an 18% reserve requirement=
Deposit multiplier = 1/.18 ≈ 5.55
So, each dollar in reserves could potentially translate to $5.55 in money supply. Lower reserve requirements mean higher potential money supply increase due to more available lending capital.
Understanding and leveraging the deposit multiplier strengthens a bank’s ability to manage reserves, ensuring robust economic activity through prudent lending practices.
Related Terms: money multiplier, reserve requirement, central bank, checkable deposits, fractional reserve banking.
References
- Board of Governors of the Federal Reserve System. “Finance and Economics Discussion Series (FEDS): Reserve Requirement Systems in OECD Countries”.
- City University of New York, Open Educational Resources. “Principles of Macroeconomics 2e: How Banks Create Money”.
