Practice
Reserves and the money multiplier
Required and excess reserves, the money multiplier, and how far lending and open-market purchases can expand the money supply.
The skill
Banks hold a fraction of deposits as required reserves, and anything above that is excess reserves they can lend. Required reserves are the reserve ratio times deposits, and excess reserves are total reserves minus required reserves. The maximum money multiplier is 1 divided by the required reserve ratio, and the most new loans the banking system can make is the excess reserves times that multiplier. Multiplying the whole deposit instead of the excess reserves is the common error. A bond purchase from banks is different: deposits do not change, so the whole purchase is new excess reserves and all of it is multiplied.
A worked example
Someone deposits $15,000 of cash into a checking account. The required reserve ratio is 20%, and banks keep no excess reserves.
What is the maximum total amount of new loans the banking system can make from this deposit, in dollars?
Solution
- The bank must hold 20% of the deposit, $3,000, so its excess reserves are $12,000.
- Excess reserves are what the system lends, round after round: 12,000 × 5 = $60,000.
Answer: 60000