How Must Banks Use the Deposit Multiplier When Calculating Their Reserves?

The deposit multiplier, or simple deposit multiplier, is the amount of cash that a bank must keep on hand in order to meet its mandated reserve requirement.

The maximum amount of a bank's "checkable" deposits cannot exceed the amount of the bank's reserves multiplied by the deposit multiplier. Checkable deposits are accounts against which checks may be written, using money loaned by the bank.

Key Takeaways

  • The deposit multiplier is used to calculate how much cash a bank must keep on hand. That cash is its required reserve.
  • The purpose of the required reserve is to ensure that banks have adequate cash to deal with an unusual number of withdrawals by customers.
  • A bank's checkable deposits cannot exceed its total reserves multiplied by the deposit multiplier.

Understanding the Deposit Multiplier

A bank's deposit multiplier is a percentage of its checkable deposits.

The deposit multiplier is part of the money supply expansion activity by a bank and is 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 Federal Reserve eliminated reserve requirements for all banks as of March 15, 2020. The move was part of its effort to keep economic activity healthy during the COVID-19 pandemic.

The Fed's action effectively sets the reserve requirements ratio at 0%.

Basics of the Reserve Requirement

The key to understanding the deposit multiplier is first understanding the reserve requirement ratio, or the proportion of reserves that banks are required to maintain by the Federal Reserve in order to adequately manage potential 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 five 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 entire 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 savings and convert some funds to currency.

Deposit Multiplier in Action

If the reserve requirement is 10%, the deposit multiplier means that banks must keep 10% of all deposits in reserve, but they can create money and stimulate economic activity by lending out the other 90%.

So, if someone deposits $100, the bank must keep $10 in reserve but can lend out $90. If the borrower gives that $90 to another party who deposits it back into the bank, the bank must keep $9 in reserve but can loan out $81.

In this manner, the bank can expand an initial deposit of $100 into $1,000. However, the higher the reserve requirement, the less money the bank is able to create using the deposit multiplier.

Article Sources

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  1. Federal Reserve. "Reserve Requirements." Accessed Dec. 18, 2021.

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