The terms “deposit multiplier” and “money multiplier” are often confused and used interchangeably, because they are very closely related concepts and the distinction between them can be difficult to grasp. The deposit multiplier provides the basis for the money multiplier, but the money multiplier value is ultimately less, due to excess reserves, savings and conversions to cash by consumers.
The Deposit Multiplier
The deposit multiplier, also known as the deposit expansion multiplier, is the basic money supply creation process that is determined by the fractional reserve banking system. Banks create what are termed checkable deposits as they loan out their reserves. The bank’s reserve requirement ratio determines how much money is available to loan out and therefore the amount of these created deposits. The deposit multiplier is then the ratio of the checkable deposits amount to the reserve amount. The deposit multiplier is the inverse of the reserve requirement ratio.
The Money Multiplier
The money multiplier reflects the amplified change in the money supply that ultimately results from the injection into the banking system of additional reserves. However, the money multiplier differs from the more basic deposit multiplier because banks tend to keep excess reserves, and bank customers tend to convert some portion of checkable deposits to savings deposits or cash.
Banks commonly keep excess reserves beyond the minimum reserve requirements set by the Federal Reserve Bank. This reduces the amount of checkable deposits and the total supply of money that is created.
Borrowers do not spend all of the money received from bank loans. If they did, and if banks loaned out every possible dollar beyond the minimum reserve requirements, then the deposit multiplier and the money multiplier would be close to exactly equivalent. In reality, borrowers typically transfer some of the money to savings deposits. Like banks keeping excess reserves, this limits the created money supply and the resulting money multiplier figure. Similarly, conversions of checkable deposits to currency reduces the money multiplier by taking away some amount of deposits and reserves from the system.