Deposit Multiplier vs. Money Multiplier: An Overview
The terms "deposit multiplier" and "money multiplier" are often confused and used interchangeably because they are very closely related concepts and the distinction between them can be difficult to grasp. The deposit multiplier provides the basis for the money multiplier, but the money multiplier value is ultimately less, due to excess reserves, savings, and conversions to cash by consumers.
- The deposit multiplier, also known as the deposit expansion multiplier, is the basic money supply creation process that is determined by the fractional reserve banking system.
- The money multiplier reflects the amplified change in the money supply that ultimately results from the injection into the banking system of additional reserves.
- The deposit multiplier provides the basis for the money multiplier, but the money multiplier value is ultimately less, due to excess reserves, savings, and conversions to cash by consumers.
The deposit multiplier, also known as the deposit expansion multiplier, is the basic money supply creation process that is determined by the fractional reserve banking system. Banks create what is termed checkable deposits as they loan out their reserves. The bank's reserve requirement ratio determines how much money is available to loan out and therefore the amount of these created deposits. The deposit multiplier is then the ratio of the amount of the checkable deposits to the reserve amount. The deposit multiplier is the inverse of the reserve requirement ratio.
A deposit multiplier minimizes the risk of a bank not having enough cash on hand to satisfy day-to-day withdrawal requests from its customers. Its reserve requirement ratio also determines how much money it has to loan out or otherwise invest.
The deposit multiplier is sometimes expressed as the deposit multiplier ratio, which is the inverse of the required reserve ratio. For example, if the required reserve ratio is 20%, the deposit multiplier ratio is (1/0.20) = 5x.
The money multiplier reflects the amplified change in the money supply that ultimately results from the injection into the banking system of additional reserves. However, the money multiplier differs from the more basic deposit multiplier because banks tend to keep excess reserves, and bank customers tend to convert some portion of checkable deposits to savings deposits or cash. Money that banks are not required to hold in reserve is redirected into funding loans, and the borrowed funds end up on the deposit accounts of other clients. The total amount of new deposits or new money that is created can be captured using the money multiplier formula.
The money multiplier is important in macroeconomics because it determines the money supply, which affects interest rates. It's also important in banking because it impacts monetary policy and the stability of the banking sector.
Banks commonly keep excess reserves beyond the minimum reserve requirements set by the Federal Reserve Bank. This reduces the number of checkable deposits and the total supply of money that is created.
Borrowers do not spend all of the money received from bank loans. If they did, and if banks loaned out every possible dollar beyond the minimum reserve requirements, then the deposit multiplier and the money multiplier would be close to exactly equivalent. In reality, borrowers typically transfer some of the money to savings deposits. Like banks keeping excess reserves, this limits the created money supply and the resulting money multiplier figure. Similarly, conversions of checkable deposits to currency reduces the money multiplier by taking away some amount of deposits and reserves from the system.