What Is a Deposit Multiplier?
A deposit multiplier, sometimes called a simple deposit multiplier, is the amount of cash that a bank must keep in reserve and is a percentage of the amount on deposit at the bank. For example, if the deposit multiplier is 20% the bank must keep $1 in reserve for every $5 it has in deposits. The remaining $4 is available to the bank to loan out or invest.
The deposit multiplier requirement is key to maintaining an economy's basic money supply. Reliance on a deposit multiplier is called a fractional reserve banking system and is now common to banks in most nations around the world.
The deposit multiplier is sometimes called the deposit expansion multiplier. This is the inverse of the required reserve ratio. 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.
Understanding Deposit Multipliers
Keeping a deposit multiplier minimizes the risk that a bank will not have 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.
Calculating a Deposit Multiplier
A deposit multiplier can be calculated using the following formula:
Central banks such as the Federal Reserve in the United States establish minimum amounts to be held by banks, known as the required reserve. The bank must continually maintain this minimum in an account deposited at the central bank to ensure that it has sufficient cash to meet any withdrawal requests from its depositors.
- The deposit multiplier is key to maintaining an economy's basic money supply.
- It is the main component of a fractional reserve banking system.
- Banks in the U.S. must keep minimums set by the Federal Reserve but may set a higher deposit multiplier.
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 80%.
Deposit Multiplier vs. Money Multiplier
The deposit multiplier is frequently confused with the money multiplier. Although the two terms are closely related, they are not interchangeable.
The money multiplier reflects the change in a nation's money supply created by the loan of capital beyond the bank's reserve. It can be seen as the maximum potential creation of money through the multiplied effect of all bank lending.
Banks may keep reserves beyond the requirements set by the Federal Reserve in order to reduce the number of checkable deposits.
If banks loaned out every available dollar beyond their required reserves, and if borrowers spent every dollar they borrowed from banks, the deposit multiplier and the money multiplier would be essentially the same.
In practice, banks do not lend out every dollar they have available. And not all borrowers spend every dollar they borrow. They may devote some of the cash to savings or other deposit accounts. That reduces the amount of money creation and the money multiplier figure that reflects it.