What is a Deposit Multiplier
The deposit multiplier, also referred to as the deposit expansion multiplier, is a function that describes the amount of money a bank creates in additional money supply through the process of lending the available capital it has in excess of the bank's reserve requirement. Simply put, it's the ratio of bank reserves to the bank deposits.
BREAKING DOWN Deposit Multiplier
The term "multiplier" refers to the fact that the change in checkable deposits resulting from the bank lending money to borrowers is a multiple of any change in the bank's level of reserves. The deposit multiplier is thus inextricably tied to the bank's reserve requirement.
Calculating a Deposit Multiplier
A deposit multiplier can be calculated as:
Central banks such as the Federal Reserve in the United States establish minimum (required reserve) amounts that a bank must continually maintain in an account at the central bank in order to ensure that the bank has sufficient cash to meet any withdrawal requests from its depositors. For example, if the required reserve ratio is 20%, this means that for every $5 deposited with a bank, the bank must hold $1 in its required reserve account. As for the excess capital the bank has available above the required reserve amount to lend to borrowers, the bank's deposit multiplier in this example is five. The deposit multiplier is sometimes expressed as the deposit multiplier ratio, which is always the inverse of the required reserve ratio. If the required reserve ratio is 20%, the deposit multiplier ratio is 80%.
The Deposit Multiplier and Money Creation
The deposit multiplier is all about a bank's ability to expand the money supply. The multiplier reflects the level of money creation that is enabled by means of the fractional-reserve banking system that only requires banks to hold a percentage of their total checkable deposits amount in reserve. The banks are then free to create a larger amount of checkable deposits by loaning out a multiple of their required reserves.
The deposit multiplier is frequently confused, or thought to be synonymous, with the money multiplier. However, although the two terms are closely related, they are not interchangeable. If banks loaned out all available capital beyond their required reserves, and if borrowers spent every dollar borrowed from banks, then the deposit multiplier and the money multiplier would be essentially the same. In actual practice, the money multiplier, which designates the actual multiplied change in a nation's money supply created by loan capital beyond bank's reserves, is always less than the deposit multiplier, which can be seen as the maximum potential money creation through the multiplied effect of bank lending.
The reasons for the differential between the deposit multiplier and the money multiplier start with the fact that banks do not lend out all of their available loan capital but instead commonly maintain reserves at a level above the minimum required reserve. Additionally, not all borrowers spend every dollar borrowed. Borrowers often devote some borrowed funds to savings or other deposit accounts, thus reducing the amount of money creation and the money multiplier figure.