# Money Multiplier – Meaning, Formula, Importance, and Factors

## What is Money Multiplier?

Money Multiplier is a concept in economics. It refers to the concept of creating money in an economy in the form of credit creation. Or, we can say it is the maximum amount of money (in the form of credit) that banks can generate by introducing changes to the money deposits. In simple words, we can say that this multiplier tells about the total money that banks can generate with each dollar of the reserve.

This concept works based on a fractional reserve banking system. We can also call it a monetary multiplier or credit multiplier.

One can usually associate the multiplier effect with commercial banks’ core function of accepting deposits. From the total deposits that bank gets, they keep a certain amount as a reserve. And, the remaining they distribute as loans, thereby, injecting the money back into the economy. This creates a multiplier effect.

The authorities or regulators across the countries have specified the quantum of money that the banks have to keep as reserve out of that deposits. This quantum is known by various names, it could be the reserve ratio, cash reserve ratio, or the required reserve ratio. So, we can call this multiplier a ratio of deposits to reserves.

## Money Multiplier Formula

One can easily calculate the money multiplier using the reserve ratio.

Following is the formula to calculate the money multiplier:

= 1/r

Here ‘r’ is the reserve ratio.

The formula implies that the higher the reserve ratio, the lower will be the multiplier. Effectively that means banks would need to keep more portion/amount of deposits as a reserve. And that will leave a lesser amount with the bank to give loans. On the other hand, a lower reserve ratio leads to a higher multiplier.

## Importance of Money Multiplier

One of the primary uses of this multiplier is to measure the changes in money supply in an economy due to the changes in reserve requirements. Thus, government and economists closely track the multiplier as it helps them to devise monetary policies. For instance, if a government decides to boost the economy, it would refer to the multiplier to determine how much money it needs to inject into the economy.

Suppose Federal Reserve wants to boost the money supply by giving businesses easy access to the capital. In this case, the Fed would lower the reserve ratio, thereby allowing banks to give more loans. And, if the Fed wants to reduce the money supply, then it would raise the reserve requirement.

## Example

Let us understand the multiplier concept with the help of an example.

Bank A has total deposits of \$10 million, and the Fed has a reserve ratio of 10%. This implies that the bank would have to keep \$1 million in reserves. The reserve would help the bank to meet the usual withdrawals from customers. So, they can give the rest of the deposit as a loan. Giving loans would raise the supply of money in an economy from \$10 million to \$19 million.

The \$9 million loans will help to further create money in the economy. This is because the borrowers will spend the money in the economy itself, i.e. on buying cars, houses, machinery, and more. Now, sellers (suppose the seller of the car) will likely put all or some of that money back into the bank. This would restart the multiplier cycle again. Banks will again keep some part of the deposits as a reserve, and give the remaining as a loan.

Now that we know about the multiplier concept (or multiplier effect), let us look at an example to understand the calculation.

Suppose the Fed decides that an economy needs an additional money supply of \$10 million more to overcome the recession. The current reserve requirement is 70%.

So, the multiplier, in this case, will be 1.42 (1/0.70). It implies that the Fed will have to inject about \$7 million (\$10 million / 1.42) to ensure the total supply of \$10 million. The multiplier effect will make \$7 million into \$10 million.

However, if the Fed lowers the reserve ratio to 10%, then the multiplier will be 10 (1/10%). It implies that to ensure a money supply of \$10 million, the Fed will need to invest just \$1 million (\$10 million/ 10).

## Factors Affecting Money Multiplier

The multiplier effect will be fully effective if all individuals deposit all the money they get into banks. However, such an assumption is not practical in the real world.

In the real world, many factors affect the multiplier. For instance, Mr. A runs a departmental store. He deposits some of his sales into the saving account, and the balance he uses to buy raw materials for his store. He will likely be paying some tax on the purchase. This tax will not go into the savings account, or we can say it will not contribute to the multiplier. So, the tax rates have a significant impact on the multiplier.

Now suppose Mr. A uses some of the money to buy a product online that was manufactured in a foreign market. In such a case, the purchase money will go outside the nation and the economy.  This would again reduce the multiplier effect.

Another factor affecting the multiplier is the tendency of some people to keep some amount in cash. This way they never deposit that amount in the bank, and they do spend it.

Some banks may also hold more reserves than the minimum reserve requirements. This would also impact the multiplier effect. A bank may hold more reserves as a cushion for bad times.

## Final Words

Money Multiplier is a very useful concept, as well as an economics tool. It helps the authorities to control the money supply in the economy. Moreover, government and central banks use it to develop effective monetary and fiscal policies.