The deposit multiplier is a fundamental concept in banking and economics that highlights the relationship between a bank’s reserves and the overall money supply. Specifically, it illustrates the change in checkable deposits that can be achieved from a change in bank reserves. The deposit multiplier is central to understanding how banks create money through the fractional reserve banking system.
How the Deposit Multiplier Works
The deposit multiplier works based on the principle of fractional reserve banking, where banks are required to keep only a fraction of their deposits as reserves, while lending out the remainder. When a bank receives a deposit, a portion of it is kept in reserve, and the rest is loaned out. The money that is loaned out eventually gets deposited in another bank, which keeps a fraction in reserve and loans out the rest, and this process continues.
Example Calculation
- Initial Deposit: Suppose a bank receives an initial deposit of $1,000 and has a reserve requirement of 10%.
- Reserves and Loans: The bank keeps $100 (10%) as reserves and can loan out $900.
- Subsequent Deposits: The $900 loan is deposited in another bank, which keeps $90 (10%) in reserves and loans out $810.
- Continued Process: This process repeats, with each subsequent bank keeping 10% of the deposit as reserves and loaning out the rest.
The sum of the deposited amounts across the banking system eventually approaches a multiple of the initial deposit.
Formula for the Deposit Multiplier
The formula for the deposit multiplier \( m \) is given by:
Where \( R \) is the reserve requirement ratio. For a 10% reserve requirement, the deposit multiplier \( m \) is:
This means that the initial deposit can potentially lead to a total increase in checkable deposits that is ten times the amount of the original deposit.
Special Considerations
Several factors can affect the actual multiplier:
- Excess Reserves: Banks may hold reserves beyond the required minimum, reducing the multiplier effect.
- Currency Drain: When individuals prefer to hold cash rather than depositing it in banks.
- Economic Conditions: During economic downturns, banks might be more risk-averse, lending less than they otherwise would.
Historical Context
The concept of the deposit multiplier has evolved with the banking system. Its significance was particularly noted during the implementation of the Federal Reserve System in the United States, which was designed to stabilize the financial system by managing reserve requirements and influencing the money supply.
Applicability
The deposit multiplier remains a critical concept in modern banking and economic policy. It helps central banks understand the implications of reserve requirements and their control over the money supply.
Related Terms
- Fractional Reserve Banking: A banking system in which only a fraction of bank deposits are backed by actual cash on hand.
- Money Multiplier: A broader concept that includes the impact of monetary policy, banking practices, and public behavior on money supply.
- Reserve Requirement: The minimum amount of reserves a bank must hold against deposits, as mandated by a central bank.
FAQs
What is the main purpose of the deposit multiplier?
How does the reserve requirement ratio affect the deposit multiplier?
Can the deposit multiplier be negative?
References
- Mishkin, Frederic S. “The Economics of Money, Banking, and Financial Markets.” Pearson, 2018.
- Federal Reserve Education. “Fractional Reserve Banking and the Money Supply.” Federal Reserve System, 2020.
Summary
The deposit multiplier is a vital concept in the banking and financial world, illustrating how banks can expand the money supply through lending activities under fractional reserve banking. Understanding its mechanism, calculating it, and considering its influencing factors are crucial for comprehending broader economic policies and their impacts on the economy.
