The maximum amount of checkable deposits a bank creates through loaning money cannot exceed the amount of the bank's reserves multiplied by the deposit multiplier. The deposit multiplier is part of the money supply expansion activity by a bank made possible with fractional reserve banking. Banks create money, or expand the money supply, in the form of checkable deposits by multiplying their required reserve amount into a larger amount of deposits. The deposit multiplier reflects the change in checkable deposits that is possible from a change in reserves, a change that always equals a multiple of the change in reserves.
The Reserve Requirement Ratio
The key to understanding the deposit multiplier is first understanding the reserve requirement ratio, or the proportion of reserves banks must maintain to manage potential customer withdrawals. The reserve requirement ratio determines the amount banks must keep in reserve and the amount banks can loan, creating additional deposits.
The deposit multiplier depends on the reserve requirement ratio. Fractional reserve banking enables banks to increase the money supply through lending excess reserves. The maximum amount of checkable deposits created by banks through making loans is limited by the reserve requirement ratio. The deposit multiplier is the inverse of the reserve requirement ratio. For example, if the bank has a 20% reserve ratio, then the deposit multiplier is 5, meaning a bank's total amount of checkable deposits cannot exceed an amount equal to 5 times its reserves.
The Money Multiplier
The deposit multiplier forms the basis of the money multiplier. The money multiplier indicates the change in actual money supply that results from a change in bank reserves. The two figures differ because banks do not loan out the total amount of their excess reserves, and because the whole amount of bank loans is not converted into checkable deposits since borrowers typically commit some funds to saving and convert some funds to currency.