Steve Bain

What is the Money Multiplier in Macroeconomics? 

The Money Multiplier in macroeconomics is a concept that is used to explain the size of the money-supply relative to the monetary base. The monetary base is simply the amount of cash in circulation, or deposited in the banking system, it is commonly denoted as M0.

M0 is the narrowest of the monetary aggregates used by the Federal Reserve, but there are other broader definitions of money such as M1 and M2 that are also used. I won't explain these definitions in this article, but suffice to say that the broader terms include different types of money/credit that get increasingly less liquid the broader that the aggregate gets. For more details on this, see my article about:

The key to understanding the simple money multiplier formula is to understand how the commercial banks can create new loans for a value that far exceeds the value of any new money that is deposited with them.

A quick example will help with this.

A Simple Multiplier Example

Imagine that $100 is added to the money supply e.g., a government welfare payment to someone. That $100 will be used by the recipient to purchase something e.g., food from the grocery store. The grocery store owner then has $100 which he deposits in his bank account.

The bank now has an initial money deposit of $100, most of which it can lend out. The recipient of this loan now purchases some new item, the seller of which receives money which he will deposit in his bank. That bank then has more deposit money with which to create yet more loans, and so on.

That same $100 dollars will be spent, deposited into a commercial bank account, and lent out again multiple times, and so it has a multiplier effect on the total level of spending in the economy.

The Multiplier Reserve Ratio

Even if everyone uses the same bank, that bank knows that it can keep lending the money to new customers because only a very small fraction of its total customers will ever want to withdraw their money at the same time, so it pays to keep only a small fraction of its liabilities (cash it owes to its customers) in reserve.

Of course, if enough of the bank's depositors turned up at once to withdraw their money, there would be a big problem because the bank has lent most of the money out to other customers. This is the essence of fractional reserve banking i.e., that only a small fraction of demand-deposits are actually held in reserve for customer withdrawals, the rest is loaned out.

The smaller the proportion of its checkable deposits that the bank holds in reserve, the bigger the multiplier will be. In practice this 'cash reserve ratio' can easily go below 5%, meaning that the other 95% or more is loaned out (assuming that the demand for loans is there at an interest rate that makes it worthwhile for the bank).

In normal times, with a typical reserve ratio of 5%, the money multiplier would work out at 20, meaning that the initial $100 injection of cash would have a $2,000 impact on the overall level of spending in the economy.

For extra clarity, imagine this in a step by step process:

  • Step 1: A $100 welfare payment is issued and spent.
  • Step 2: The $100 enters the banking system, and $95 is loaned out.
  • Step 3: The $95 is spent and re-enters the banking system.
  • Step 4: A new loan of $90.25 is made i.e. ($95 x 0.95).
  • And so on.

Each time that the money is deposited in the banking system, 5% of it is kept in reserve, the other 95% is loaned out. Eventually, with a 5% reserve ratio, a total of $2,000 will have been loaned out. That's 20 times bigger than the initial $100 welfare payment.

There are times when commercial banks are reluctant to increase their money lending on the high street, perhaps because the system has entered a liquidity trap. In such circumstances they will instead increase lending to financial intermediaries, who will invest in various interest-earning financial assets.

Additionally, any given bank can lend some of its reserves to another bank at the 'Federal Funds Rate', and earn interest on those reserves (referred to as IOR). At the same time, the banking system as a whole can lend its excess reserves to the Federal Reserve Bank, earning interest on excess reserves (referred to as IOER), a process also known as the 'reverse repo'.

This sort of internal lending has been commonplace since the 2008 financial crisis, and M2 has increased dramatically since that time. That extra money/credit had, until 2022, fueled an ever larger stock market and real estate bubble.

Simple Money Multiplier Formula

The money multiplier formula can be expressed as one of the simplest equations in Economics:

Money Multiplier = 1/r

(Where r is the banking system reserve ratio expressed as a decimal)

So, if the banking sector has a reserve ratio of 8%, the multiplier would be 1 divided by 0.08, which equals 12.5. But, if the banking sector then lowered its reserve ratio to 4%, the multiplier would double to 25, and the economy's money-supply would also double!

This demonstrates the fact that commercial bank money has enormous power in the economy to manufacture spending increases/decreases by adjusting their preferred reserve ratio by a few percentage points.

At one time commercial banks were subject to a government mandated ‘required reserve ratio’, but now there is no such reserve requirement, only a somewhat arbitrary 'capital adequacy ratio' following the Basel 3 regulations after the 2008 financial crisis.

The crisis had been fueled by excessive bank lending, primarily in the form of mortgages on property, which led to an explosion of real estate prices that far exceeded borrowers' ability to repay if they were to suffer a loss of income. When the crisis hit, many borrowers did suffer a loss of income, and the resulting defaults on mortgage payments led to a liquidity crisis that almost collapsed the entire global financial system.

Immediate catastrophe was only prevented by enormous injection of money into the banking system via 'quantitative easing', and that led to serious questions being asked about the long-term viability of the fractional reserve banking system, with its destabilizing power to manufacture spending booms.

How to stop the Multiplier Effect

The best alternative to the money multiplier system is one in which the reserve ratio is 100%. In a system of Full Reserve Banking, the multiplier would be equal to one. You can see this by referring to the simple formula above, only this time r=1.

This system also nullifies any Fractional Reserve Fraud claims, because money lending would not be allowed if it meant that the total value of bank reserves fell below the amount of money held in bank demand-deposits.

This means that the banks would always have access to the full amount of their depositors' money (meaning demand-deposits or current account money - savings accounts could still be lent out if depositors agreed that access to their savings would be time-restricted in return for higher interest earnings). The point is that the banks would always be able to pay out as promised, and any bank-run could be satisfied without any need for the government to provide assistance.

People sometimes worry that there would be insufficient credit in a full reserve system, but this is a misunderstanding, it is only excessive credit creation during an unsustainable boom that is eliminated.

The full reserve banking system could restore the free-market's ability to determine how much credit there is in the system at any given time, because the interest rate could be allowed to fluctuate to whichever rate brought equilibrium i.e., an interest rate that induced just the right supply of saving to match the demand for borrowing. Overall spending would be extremely stable, because for extra borrowing to occur, extra saving must also occur to balance it out.

Required Reserve Ratio Vs Capital Adequacy Ratio

As mentioned above, at one time the Federal Reserve had a formal 'required reserve ratio' that it imposed on the commercial banks in order to control its ability to create excessive amounts of credit. This was a common tool of monetary policy, but it no longer exists in any formal way.

The problem was that, at times when a change was deemed desirable, the financial markets would respond poorly. For example, if the reserve requirement were to be raised significantly, it might be seen as a sign that there is excessive risk in the system and thereby cause a crash in asset prices.

Instead, and following the 2008 Financial crisis, central bankers from around the world met in Switzerland where they agreed the Basel 3 Accord. One of the new regulations on banking included the introduction of a 'capital adequacy ratio'.

This new requirement does not specify any particular reserve ratio, rather it seeks to ensure that banks hold enough capital in sufficiently liquid form such that its operating risk is acceptably low.

The Multiplier in the Real World

The standard macroeconomics textbook explanation of the multiplier is a little simplistic in most scenarios, and there are many scenarios where the total money in circulation seems to follow a somewhat random path.

Many respected economists assert that the model of money creation described by the multiplier process is broken because, when the Fed increases/decreases the amount of base money, total money does not immediately respond. However, this misses the point that the commercial banks are free to determine whatever reserve ratio they want.

If they do not wish to create more loans simply because the Fed has increased base money, then they will not. Similarly, if the Fed keeps base money constant, the commercial banks can still create more or less money by adjusting their reserve ratios.

Constraints and Incentives

Ultimately, the banks are still constrained by the amount of base money in the system, but when certain lending opportunities appear particularly lucrative, we should not be surprised if they choose to reduce their reserve ratios and create more loans.

This incentive is made far worse when, in the event that the banks become insolvent due to excessive lending, the Fed steps in and bails them out with unlimited quantitative easing. This creates a win-win situation for the banks whereby they win if they lend, and they win if the taxpayer is forced to cover their losses.

In an unfair fractional reserve banking system, the money multiplier effect creates perverse incentives for bankers to over-lend and fuel unsustainable booms in the economy. The lack of accountability on their part creates a serious market failure known as 'moral hazard'.

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