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The money multiplier explains how base money, also known as the monetary base, can grow exponentially through the money creation process within a fractional reserve banking system. Essentially, every new unit of base money injected into the economy has the potential to multiply significantly as it circulates through banks and fuels lending activity. The magnitude of this multiplication effect is determined by the reserve requirement ratio.
A lower reserve requirement allows banks to lend out a larger portion of their deposits, leading to a higher money multiplier and a greater increase in the money supply. This strategy is often employed by central banks during expansionary monetary policy to stimulate economic growth.
Conversely, a higher reserve requirement ratio restricts the amount banks can lend, resulting in a lower money multiplier and a smaller increase in the money supply. This approach is used by central banks during contractionary monetary policy to combat inflation.
Money multiplier formula and calculations
The money creation process requires banks to multiply money. The mechanism works through deposits, loans, and bank reserves.
The reserve requirement ratio is the share of deposits that banks must hold as a reserve. For example, the central bank sets a reserve requirement ratio of 10%. That means that from every $100 deposit, banks can use $90 to lend and keep $10 ($100 x 10%) as a reserve.
Say, someone deposits $100 into Bank B. Bank B lends $90 to a debtor. The debtor uses the money to buy goods from a seller.
The seller then deposits $90 in money to Bank C. The bank sets aside $9 as a reserve ($90 x 10%) and lends $81 to its customers. The customer then uses the money to pay a professional consultant.
The professional deposits the money into Bank D. Bank D then sets aside $8.1 ($81 x 10%) as a reserve and lends the remainder ($72.9).
The process continues until the total amount of money in the economy increases several times. From an initial monetary base of $100, the money circulating in the economy increased to $1.000 through a money creation process. This multiple is known as a money multiplier, and we can calculate it using the formula:
- Money multiplier = 1 / Reserve requirement ratio
In the above case, because the base money is $100, the money multiplier equals $100 x (1/10%) = $1.000.
Money multiplier and monetary policy
The money multiplier isn’t just a theoretical concept; it plays a crucial role in monetary policy, the actions taken by a central bank to influence economic activity and inflation. By adjusting the reserve ratio, the central bank can indirectly control the money multiplier and influence the amount of money circulating in the economy.
Tighter monetary policy to tame inflation
From the formula above, we know that when the central bank increases the reserve requirement ratio, the fewer excess reserves there are, the less money the bank can lend, thereby reducing the money multiplier.
The central bank usually raises the reserve requirement ratio when the economy is overheated (high inflationary pressure). To prevent hyperinflation, the central bank will raise the ratio so that it causes the weakening of aggregate demand and moderates inflation and economic growth.
Loose monetary policy to stimulate economic growth
Conversely, the central bank will reduce the reserve requirement ratio when implementing expansionary monetary policy. A decrease in the reserve ratio means that the higher the excess reserves, the more money the bank has to lend, and this encourages a higher money multiplier.
As more money circulates, economic liquidity increases, pushing interest rates down. Declining interest rates make borrowing costs cheaper, encouraging spending on goods and services to increase.
Increased demand for goods and services encourages businesses to increase output and recruit more workers. As a result, the economy is growing, unemployment is falling, and inflation is creeping up.
Criticisms and limitations of the money multiplier
The money multiplier is a powerful tool for understanding money creation, but it’s important to acknowledge its limitations. Here’s why:
Currency drain
Money multipliers work through the fractional banking system. And, in fact, not all money is deposited in banks.
For example, we keep holding cash in hand instead of keeping it in the bank just in case. Other individuals may put money in a savings and credit cooperative (which is not bound by the terms of the reserve requirements). The part of a currency outside the fractional banking system is called the currency drain.
Currency drain reduces the money multipliers that banks can create. To account for the currency drain, economists use a modified version of the money multiplier formula:
- Money multiplier = (1 + Currency drain ratio) / (Required reserve ratio + Currency drain ratio)
This formula incorporates the currency drain ratio, which reflects the proportion of money held outside the banking system. A higher currency drain ratio reduces the overall impact of the money multiplier.
Other factors affecting money creation
The money multiplier is a simplified model, and several other factors can influence money creation:
- Bank lending practices: Banks might choose to hold more reserves than the minimum required ratio, depending on their risk assessment and liquidity needs.
- Public confidence: If people lose faith in the banking system, they might be more likely to withdraw their money and hold onto cash, further increasing the currency drain.
- Changes in economic sentiment: Depending on their economic outlook, businesses and consumers might be more or less likely to borrow and spend, impacting the velocity of money circulation (how often money changes hands).
