Wednesday  April 17, 2024
 AmosWEB means Economics with a Touch of Whimsy!
 ADVERSE SELECTION: When a negotiation between two people with different amounts of information, that is, asymmetric information, restricts the quality of the good traded. This typically happens because the person with more information is able to negotiate a favorable exchange. This is frequently referred to as the "market for lemons."

MONEY MULTIPLIER:

The ratio of the change in money to the change in bank reserves. The money multiplier indicates the magnified change in money (checkable deposits and currency) that results from an injection of additional reserves into the banking system. As the name suggests, the change in money is typically a multiple of the initial change in bank reserves. The deposit expansion multiplier also forms the core of the money multiplier, both of which depend on the reserve requirement ratio.
The money multiplier measures the change in money (checkable deposits and currency) resulting from a given change in bank reserves. The term "multiplier" indicates that the change in money is inevitably a "multiple" of the initial change in bank reserves. The core of this multiplier is the reserve requirement ratio and the money creation activities of fractional-reserve banking.

However, the money multiplier differs from the simple deposit expansion multiplier (which is the inverse of the reserve requirement ratio) because banks are prone to keep some excess reserves and borrowers are inclined to transfer checkable deposits into savings deposits and currency.

### The Money Multiplier Equation

The change in the money supply resulting from a given change in bank reserves is indicated by a simple equation:
M = mR
In this equation M represents the change in the money supply, R is the number of excess reserves added to the banking system, and m is the multiplier.

### The Deposit Expansion Multiplier

The core of the money multiplier is the simple deposit expansion multiplier, which is the inverse of the reserve requirement ratio. The deposit expansion multiplier numerically captures the money creation process undertaken by the fractional-reserve banking system. As banks lend out excess reserves, they create checkable deposits. The amount of deposits created depends on the reserve requirement ratio.

A lower ratio means more checkable deposits can be created and a higher ratio means less can be created for a given amount of reserves. The ratio of checkable deposits created to the amount of reserves is the deposit expansion multiplier.

Suppose, for example, that the Federal Reserve System (Fed) injects \$100 of excess reserves into the banking system. In addition, suppose that the reserve requirement ratio is 10 percent, meaning that banks must keep reserves equal to at least 10 percent of deposits. The banking system will use this \$100 of excess reserves to back up, or create, ten times the amount of checkable deposits. The deposit expansion multiplier in this case is equal to 10. The money multiplier, however, is likely to be less.

The money multiplier differs from the deposit expansion multiplier for three key reasons.
• One: Excess Reserves: In theory, banks are motivated by the pursuit of profit to convert all excess reserves into loans, creating checkable deposits along the way. If they do, then the deposit expansion multiplier (and thus money multiplier) is equal to the inverse of the reserve requirement ratio. However, in practice, banks are often inclined to keep a few extra reserves. The Fed might set the MINIMUM reserve requirement ratio at 10 percent, but banks realize they actually need 11 percent. Maybe the banks want to be a little safer. Maybe they know a little more than the Fed about their customers and the reserves they need to conduct business. Keeping extra reserves limits the amount of checkable deposits and money created.

• Two: Saving Deposits: In theory, borrowers spend all of the checkable deposits received from their bank loans. If so, then the deposit expansion multiplier (and thus the money multiplier) is equal to the inverse of the reserve requirement ratio. However, in practice, borrowers often transfer a portion of their checkable deposits to savings deposits. Because savings deposits have different reserve requirements (usually zero) and because savings deposits are not "spent," this undercuts the money creation process. Transferring checkable deposits to savings deposits limits the amount of money created and the size of the money multiplier.

• Three: Currency: On a similar note, borrowers are also inclined to convert checkable deposits into currency. The transfer of wealth between checkable deposits and currency has not immediate effect on the money supply. However, by removing deposits and reserves from the banking system, it does affect the deposit and money creation process. Transferring checkable deposits to currency limits the amount of money created and the size of the money multiplier.
While the simple deposit expansion multiplier--the inverse of the reserve ratio--is a great place to start when specifying the money multiplier, it is ONLY a start.

For anyone assigned the job of controlling the amount of money in circulation and conducting monetary policy (which is actually what the Fed does), they need to know more than the simple deposit expansion multiplier, the inverse of the reserve requirement ratio, they would need to know the money multiplier. Fortunately the folks at the Federal Reserve System do have an excellent grasp of this money multiplier and they use this information when conducting monetary policy.

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Recommended Citation:

MONEY MULTIPLIER, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: April 17, 2024].

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