What Is a Deposit Multiplier?
The deposit multiplier is the maximum amount of money a bank can create for each unit of reserves. The deposit multiplier is normally a percentage of the amount on deposit at the bank. 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 the maximum amount of money a bank can create for each unit of reserves.
- This figure is key to maintaining an economy's basic money supply and the main component of a fractional reserve banking system.
- Although minimums are set by the Federal Reserve, banks may set a higher deposit multiplier.
- The deposit multiplier is different from the money multiplier which reflects the change in a nation's money supply created by the loan of capital beyond a bank's reserve.
Understanding Deposit Multipliers
The deposit multiplier is also called the deposit expansion multiplier or the simple deposit multiplier. This is the amount of money all banks must keep on hand in their reserves. It allows them to function on a day-to-day basis, cutting the risk of depleting their supplies to satisfy withdrawal requests from their customers.
Central banks such as the Federal Reserve in the United States establish minimum amounts to be held by banks. These are known as the required reserve or reserve requirement—the amount of money available for a bank to lend to its customers. 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 the inverse of the required reserves. So if the required reserve ratio is 20%, the deposit multiplier ratio is 80%. It is the ratio of the amount of a bank's checkable deposits—demand accounts against which checks, drafts, or other financial instruments can be negotiated—to its reserve amount. So if the deposit multiplier is 80%, the bank must keep $1 in reserve for every $5 it has in deposits. The remaining $4 is available to the bank to lend out or invest.
The deposit multiplier provides the basis for the money multiplier, but the money multiplier value is ultimately less. That's because of excess reserves, savings, and conversions to cash by consumers. We go into more detail about money multiplier a little further down.
A bank's deposit multiplier can be calculated using the following formula:
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 and are distinctly different. The money multiplier reflects the change in a nation's money supply created by the loan of capital beyond a 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.