What is the ‘Multiplier Effect’
The multiplier effect is the expansion of a country’s money supply that results from banks being able to lend. The size of the multiplier effect depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is the money used to create more money and is calculated by dividing total bank deposits by the reserve requirement.
BREAKING DOWN ‘Multiplier Effect’
To calculate the effect of the multiplier effect on the money supply, start with the amount banks initially take in through deposits, and divide this by the reserve ratio. If, for example, the reserve requirement is 20%, for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend out the remaining $64.
This cycle continues as more people deposit money and more banks continue lending it until finally the $100 initially deposited creates a total of $500 ($100/0.2) in deposits. This creation of deposits is the multiplier effect.
The reserve requirement is set by the board of governors of the Federal Reserve System, and it varies based on the total amount of liabilities held by a particular depository institution. For example, as of 2016, institutions with more than $110.2 million in deposits are required to hold 10% of their total liabilities in reserve.
Money Supply and the Multiplier Effect
The money supply consists of multiple levels. The first level, referred to as the monetary base, refers to all of the physical currency in circulation within an economy. The next two levels, M1 and M2, add the balances of deposit accounts and those associated with small-denomination time deposits and retail money market shares, respectively.
As a customer makes a deposit into an M1 deposit account, the banking institution can lend the funds beyond the reserve to another person. While the original depositor maintains ownership of the initial deposit, the funds created through lending are generated based on those funds. If the borrower subsequently deposits the funds received from the lending institution, this raises the value of M1 even though no additional physical currency actually exists to support the new amount.
The higher the reserve requirement, the tighter the money supply, which results in a lower multiplier effect for every dollar deposited. This may make financial institutions less inclined to lend as their options to do so are limited based on the size of the reserve. In contrast, the lower the reserve requirement, the larger the money supply, which means more money is being created for every dollar deposited, and financial institutions may be more inclined to take additional risks with the larger pool of available funds.