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

M = mR

The Deposit Expansion Multiplier

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.

Three Adjustments

• 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.