Multiplier Effect


DEFINITION of 'Multiplier Effect'

The expansion of a country's money supply that results from banks being able to lend. The size of the multiplier effect depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is money used to create more money and is calculated by dividing total bank deposits by the reserve requirement.


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BREAKING DOWN 'Multiplier Effect'

The multiplier effect depends on the set reserve requirement. So, to calculate the impact of the multiplier effect on the money supply, we start with the amount banks initially take in through deposits and divide this by the reserve ratio. If, for example, the reserve requirement is 20%, for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend out the remaining $64. This cycle continues - as more people deposit money and more banks continue lending it - until finally the $100 initially deposited creates a total of $500 ($100 / 0.2) in deposits. This creation of deposits is the multiplier effect.

The higher the reserve requirement, the tighter the money supply, which results in a lower multiplier effect for every dollar deposited. The lower the reserve requirement, the larger the money supply, which means more money is being created for every dollar deposited.

  1. Monetary Policy

    Monetary policy is the actions of a central bank, currency board ...
  2. Velocity Of Money

    The rate at which money is exchanged from one transaction to ...
  3. Reserve Requirements

    Requirements regarding the amount of funds that banks must hold ...
  4. Money Supply

    The entire stock of currency and other liquid instruments in ...
  5. Federal Reserve System - FRS

    The central bank of the United States. The Fed, as it is commonly ...
  6. Reserve Ratio

    The portion (expressed as a percent) of depositors' balances ...
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