Deposit Multiplier

The deposit multiplier is the process by which an economy's basic money supply is created. It reflects the change in checkable deposits possible from a change in reserves. Simply put, it's the ratio of bank reserves to the bank deposits.

The deposit multiplier is determined by the fractional reserve banking system, and is also called the deposit expansion multiplier.

The deposit multiplier is all about a bank's ability to expand the money supply, and is the inverse of its reserve requirement ratio. This is the total amount of money a bank must hold on to in order to satisfy withdrawal requests from its customers. The bank's reserve requirement ratio also determines how much the bank has to loan out and the amount of these deposits.

The deposit multiplier reflects the level of money creation enabled by the fractional-reserve banking system. This system only requires banks to hold a percentage of their total checkable deposits amount in reserve. The banks can then create a larger amount of checkable deposits by loaning out a multiple of their required reserves.

[Important: Banks may keep reserves beyond the requirements set by the Federal Reserve to reduce the amount of checkable deposits.]

A deposit multiplier can be calculated using the following formula:

Central banks such as the Federal Reserve in the United States establish minimum amounts known as the required reserve. This is the amount a bank must continually maintain in an account at the central bank to ensure it has sufficient cash to meet any withdrawal requests from its depositors.

So if the required reserve ratio is 20%, this means that for every $5 deposited with a bank, the bank must hold $1 in its required reserve account. As for the excess capital above the required reserve amount, the bank's deposit multiplier in this example is five. The deposit multiplier is sometimes expressed as the deposit multiplier ratio, which is always the inverse of the required reserve ratio. If the required reserve ratio is 20%, the deposit multiplier ratio is 80%.

• The deposit multiplier is the process by which an economy's basic money supply is created.
• It is determined by the fractional reserve banking system, and reflects the change in checkable deposits possible from a change in reserves.
• Central banks determine how much banks should hold in their reserves, and therefore, how much they can lend out.

The deposit multiplier is frequently confused or thought to be synonymous with the money multiplier. Although the two terms are closely related, they are not interchangeable.

If banks loaned out all available capital beyond their required reserves, and if borrowers spent every dollar borrowed from banks, the deposit multiplier and the money multiplier would be essentially the same. The money multiplier, which designates the multiplied change in a nation's money supply created by loan capital beyond bank's reserves, is always less than the deposit multiplier. It can be seen as the maximum potential money creation through the multiplied effect of bank lending.

The reasons for the differential between the deposit multiplier and the money multiplier start with the fact that banks do not lend out all of their available loan capital. Instead, they commonly maintain reserves at a level above the minimum required reserve. Additionally, not all borrowers spend every dollar borrowed. Borrowers often devote some borrowed funds to savings or other deposit accounts, thus reducing the amount of money creation and the money multiplier figure.