SIMPLE DEPOSIT MULTIPLIER

The deposit multiplier is the maximum amount of money that a bank can create
for each unit of money it holds in reserves.

(This figure is key to maintaining an economy’s basic money.)

The deposit multiplier is also called the deposit expansion multiplier or the
simple deposit multiplier. It’s connected to the portion of bank’s deposits that can
be lent to borrowers.

(This lending activity injects money into the nation’s money supply and supports
economic activity. Essentially, the deposit multiplier is an indicator of how banks can
increase, or multiply, deposits.)

Banks must maintain reserves apart from what they loan to ensure that they have
sufficient cash to meet any withdrawal requests from depositors.

Example: a woman wants to open a checking or demand deposit at Anchor Bank

with $10,000 cash. We agree to open the account for her. We take her $10,000,
and put it in the bank’s vault, and proceeds to have her sign the proper forms to
open deposit account.

(So, the question, how are we going to apply the simple deposit multiplier and how
much of the $10,000 should the bank lent out?)

The federal reserve establishes minimum amounts that banks must hold in
reserve. The amounts are known as required reserves.

The Required Reserve Ratio – is the portion of deposits banks must hold in the
form of cash reserves. These reserves may be held in the form of vault cash/ or
deposits at the Central Bank.

 (Let us suppose that the anchor bank contacts their regulator and discover that,
for this type of account in their bank, the required reserve ratio is 10%.)

 That is, we have to hold 10% of the $10,000 deposit – or $1,000 - in the form of
reserves.
 The reserves in excess of the required reserves that a bank hold is called
“excess reserves”

Total reserves = Required reserves + Excess reserves

Thus, here we have:

$10,000 = $1,000 + $9,000

It is the $9,000 in excess reserves we would like to lent out. In order to make new
money.

Suppose, that virgelio, is interested in borrowing money because he wants to buy a car.
He is interested in borrowing $9,000. The exact amount that the bank would like to lent
out. So, after performing the calculations and determine virgelio can comfortably afford
the monthly payments to repay the $9,000 plus interest.

The money supply process is not going to stop there. Once virgelio finds a car that he
likes, he is going to write out a check to the car seller. And that seller will be going to
deposit that amount into their bank account, let say at Citi Bank. Now Citi Bank now has
a new deposit of $9,000.

As we just described, when a bank receives a deposit, it wants (or needs) to lend out
the majority of that deposit. If we assume that Citi Bank also required reserve ration of
10%, it will hold 10% of $9,000 (or $900) in the form of reserves and lent out the
remaining $8,100. When it does so, Citi Bank will create $8,100 of new money.

This new $8,100 will be deposited into another bank that will again hold 10% in
reserves ($810) and lend out the remaining $7,290, when it does so, this bank will
create $7,290 of new money. And the process repeats.

Simple Deposit Multiplier Formula:

Deposits = Money Supply = Initial deposit x (1/ RRR)

Deposits = Money supply = $10,000 x (1/0.10) = $100,000

Deposits = Money supply = $10,000 x (1/0.20) = $50,000

NOTE: THE LOWER THE RESERVE REQUIREMENT, THE GREATER THE AMOUNT
OF MONEY THAT CAN BE CREATED BECAUSE MORE MONEY IS TO BE LENT)

In conclusion - the deposit multiplier is an indicator of how banks can increase, or

multiply, deposits.