Money Multiplier

See: Multiplier Effect.

The money multiplier creates the multiplier effect: when a bank lends out a dollar, that person spends it, which is another dollar in someone else’s bank account to spend, and on and on and on. This is one way that the Fed can try to create economic growth: entering more money into the money supply by giving it to banks to lend out, which leads to more spending.

Obviously people save some money—they don’t spend it all. If, on average, everyone spends 80 cents on the dollar when the economy is up and money is good...then the money multiplier is bigger than when everyone on average spends 60 cents on the dollar, when money is tight and the economy is down.

Let’s say Joe deposits $2k in the bank. The bank keeps 10% of that $2k to fulfill reserve requirements, then lends out the remaining 90%, which is $1,800. That money is lent out to Joe’s sister, Josephine, who deposits that $1,800 in her bank account. Josephine’s bank does the same thing: it keeps 10% on hand, lends out the other 90%, which is now $1,620, and on and on and on. This is how the money multiplier works, creating more money through lending by banks and spending by consumers.

Here, our money multiplier is 1 divided by the reserve requirement, which is 10%.

1 / 0.1 = 10.

So from the initial $2k deposit, the maximum amount of expansion we’d expect is $1,800 (the first depositing of the money) times 10, the money multiplier, which equals $18k.

Money doesn’t grow on trees...it multiplies.