# Multiplier Effect

## What is the 'Multiplier Effect'

The multiplier effect is 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.

RELATED TERMS
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RELATED FAQS
1. ### What is the difference between the deposit multiplier and the money multiplier?

Explore the deposit multiplier and the money multiplier, two fundamental concepts of Keynesian economics, and learn how they ... Read Answer >>
2. ### How must banks use the deposit multiplier when calculating their reserves?

Explore the relationship between the deposit multiplier and the reserve requirement, and learn how this limits the extent ... Read Answer >>
3. ### What does a large multiplier effect signify?

Find out more about the multiplier effect, what it measures and what a large multiplier effect indicates about an economy. Read Answer >>
4. ### How does the deposit multiplier affect a bank's profitability?

Find out how a deposit multiplier affects bank profitability, how it increases the supply of money in the economy and why ... Read Answer >>
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