Alternate names: Deposit expansion multiplier, simple deposit multiplier
For example, if a bank has $100 million in demand deposits and a reserve requirement of 5%, it must keep $5 million in its reserve, but can lend the other $95 million (or 95%) out in the form of loans and credit. This is called fractional banking, and it’s a tool used to help expand the economy, in part, by offering consumers money they can borrow to make purchases.
How a Deposit Multiplier Works
Whenever you deposit money into your bank account, your bank is legally required to hold onto a percentage of it. This percentage is known as the “reserve requirement,” and it’s set by the Federal Reserve. For example, suppose the federal reserve requirement is 5% and you deposit $1,000 into your bank account. Your bank puts $50 in its reserves and loans the other $950 out to someone else. That person can then spend the full $950 they borrowed, and when the bank’s payees deposit that money into each of their bank accounts, their banks repeat the process of saving some and lending out the rest. Thus, the bank multiplies your initial $1,000 deposit into even more money. The deposit multiplier formula looks like this: Deposit multiplier = 1 / reserve ratio So if the required reserve ratio is 20%, the deposit multiplier is five. This means that for every $1 the bank has in reserves, it can increase the money supply by up to $5. If the reserve ratio was 10%, the deposit multiplier would be 10, and the bank could increase the money supply by $10 for every $1 in reserves. In essence, the lower a bank’s required reserve ratio, the higher the deposit multiplier will be and the more money it can lend out to customers.
The Deposit Multiplier and the Economy
The deposit multiplier is one of the major mechanisms central banks and financial authorities such as the Federal Reserve use to control the money supply in an economy. The Fed uses three other monetary policy tools to control the money supply in an economy. The first is open market operations, which involve purchasing or selling government securities to affect the money supply. The second is reserve requirements, which are mandatory deposit amounts financial institutions have to keep on deposit at a bank. The third is interest rates, which influences the interest rates offered by banks and lenders.
Deposit Multiplier vs. Money Multiplier
The deposit multiplier sometimes gets confused with “money multiplier,” but the two are different concepts. Think of the deposit multiplier as a best-case what-if scenario. It represents the maximum amount of money banks could potentially create through lending. In reality, this maximum amount is never reached because banks don’t lend out 100% of their excess reserves, and customers don’t always spend 100% of their loans. Thus, the money multiplier represents the actual change to the money supply created through lending. It’s usually lower than the deposit multiplier because it accounts for “leaks” that occur when borrowers hold onto some of their loans in cash or exchange them for other currencies.
