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What is the Multiplier Effect?

Definition: The Multiplier Effect is the influence that banks have on the countryís money supply when they are able to lend to consumers and businesses. In other words, bank deposits can increase the money supply when they are lent to consumers and institutions.

What Does Multiplier Effect Mean?

What is the definition of multiplier effect? More broadly, this concept is simply the expansion of economic activity due to the increase of one single activity. This can take place in many different areas of the economy, but weíll focus on lending and the money supply.

The Federal Reserve watches this effect closely to see what banks are holding in reserves. As banks hold more in reserves, less individuals and business receive loans restricting the amount of cash available in the economy. This also closely affects bank profits, because if the bank holds more money in reserves that means less money they can lend out and earn interest on.

If the Federal Reserve wants to increase the money supply, it will decrease the reserve requirements of banks, allowing them to lend more allowing that money to cycle through the economy. As you can see, this small activity of changing the reserve requirements has huge effects on the entire economy because it gets multiplied by every bank and every account holder throughout the economy. Itís like throwing a pebble in a pond. Eventually, the ripples will cover the entire surface.

The multiplier effect equation assumes that all money loaned out by the bank is deposited again and is calculated like this:

ME = (customer deposit) / (percentage of bank funds in reserves)

Letís look at an example.

Example

After a financial crisis, the Federal Reserve wanted to increase stability and consumer confidence, so it drastically increased the required reserves of banking institutions from 20% to 50%. Letís see how this will effect a bank with total customer deposits of $2,000,000.

Before the Fed raised the reserves, this money would generate (2,000,000 / (0.2)) = $10,000,000 in money throughout the economy. This money would be lent out by banks to businesses, entrepreneurs, and other companies to invest and grow.

However, since the Fed raised the required reserves, this amount has decreased to (2,000,000 / (0.5)) = $4,000,000. This decreased lowered the banks ability to lend money to businesses and restricted the overall money supply.

Some economists have even argued that this increase in required reserves was a reason for the lower than expected growth of our economy after the recession.

The multiplier effect can be seen in many other areas of the economy as well. Take demand for a product for example. As demand increases companies need more employees to produce more of that product. These employees are paid more money and have additional money to spend on other goods raising the demand for these goods and so on.

Summary Definition

Define Multiplier Effect: ME means the ability banks have to influence the ecomony by lending money to businesses.

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