What is the Money Multiplier?

//What is the Money Multiplier?
What is the Money Multiplier? 2017-10-06T00:40:18+00:00

Definition: The money multiplier, sometime called the monetary multiplier, measures the effect that a change in banks’ required reserves has on the overall money supply of an economy.

What Does Money Multiplier Mean?

What is the definition of money multiplier? The monetary multiplier is a measurement of the potency of central bank stimulus in the economy. It is a metric that is closely watched by governmental agencies and their economists. Every time the government thinks that it needs to kick-start the economy, it looks to the multiplier to help decide how much stimulus should be applied and in what way.

For instance, the FED might want to increase the money supply and make it easier for businesses to access capital. If the FED lowers the required reserves, banks can loan out more money to individuals and businesses because the ratio of deposits kept as a reserve is lower than it was. The opposite it true if the FED wants to decrease the money supply.

Let’s look at an example.

Example

Benjamin is the head of the Federal Reserve, and the United States is a few years into one of the most devastating recessions in its history. He decides to conduct an investigation into how much money the economy needs to begin to turn around and tasks his economists with deciding how much stimulus the Federal Reserve should distribute.

The economists meet and eventually decide that the economy needs $5,000,000,000 in order to stimulate investment and economic growth. What are the Fed’s tools to stimulate the economy?

First, they look to the percent of reserves that banks are holding currently: 70%. This means that the banks lend out only 30% of their funds, and hold the rest. This drastically decreases the potential for investment, and the economists know that if they lower the banks’ reserves requirements, they will loan out more money. This is because the money multiplier formula is calculated as Deposits divided by Reserve Requirement. According to this, if the economy needs $5,000,000,000 and the current reserve requirement is 70%, the monetary multiplier is only 1 / .7 = 1.42. This means that the Federal Reserve needs to inject ($5,000,000,000 x 0.7) = $3,500,000,000.

Conversely, if the FED reduces the reserve requirement to 10%, the money multiplier is 1 / (.1) = 10. This means that in order to stimulate the economy by $5,000,000,000 then The Fed only needs to invest $500,000,000. This drastically reduces the effect on The Fed, and shows how important banks are to the circulation of money in the economy.

Summary Definition

Define Money Multiplier: Monetary multiplier means the influence a central bank has over the money supply by altering the required banking reserve rate.