Changes in the Nation’s Money Supply

Let’s assume that banks hold on to 20% of all deposits. This means that a new deposit of $1,000 will allow a bank to loan out $800. This $800 will be spent, then received by person B, and deposited into bank B. Bank B, in turn, can loan out 80%, or $640. Similarly, bank C can loan out 80% of $640, or $512. This process continues indefinitely. Thus, the initial $1,000 deposit has created demand deposits of an additional $800 plus $640 plus $512, etc. Mathematically, it can be proven that the total increase in the money supply amounts to $5,000 (5 times the initial deposit of $1,000).

In general, the following equation illustrates how a nation’s total money supply changes:

Change in the nation’s money supply = money multiplier x the initial new deposit
(money multiplier times the initial new deposit)

The Money Multiplier

Similar to the multiplier in the Keynesian model, there is a multiplier in the money creation model. The formula for the money multiplier is

Money multiplier = 1 / required reserve ratio
(one divided by the required reserve ratio)

 

In the above example:
The initial deposit is $1,000.
The required reserve ratio is 20%.
So the money multiplier is 1 / 20% = 1 / .20 = 5.
So the change in the nation’s money supply is 5 times $1,000 = $5,000.

The money multiplier process can be illustrated through the following changes in banks’ balance sheets.

1. Bank A receives a (new) deposit of $1,000:

BANK A
Assets Liabilities
Bank Reserves     $1,000
Demand Deposits   $1,000
Loans              $0

2. Of this $1,000 in total reserves, the bank is required to keep 20%, or $200, and it can loan out the other 80%, or $800. Let’s say the bank decides to do so the next day. Then it shows the following balance sheet:

BANK A
Assets Liabilities
Bank Reserves      $200
Demand Deposits   $1,000
Loans              $800

3. Let’s say that the $800 loan is made to business Z, which spends the money on, for example, tickets to a baseball game. The baseball franchise deposits the revenue in its account with bank B:

BANK B
Assets Liabilities
Bank Reserves     $800
Demand Deposits   $800
Loans              $0

4. And after loaning 80% of its deposits, bank B’s balance sheet the next day is

BANK B
Assets Liabilities
Bank Reserves     $160
Demand Deposits   $800
Loans             $640

5. Let’s say that the $640 in loan money is accepted by business XYZ, which spends it on a trip to California through airline QRS. Airline QRS then deposits the $640 in its account with bank C, etc.

6. The total accumulation of money in the form of demand deposits (transaction accounts), an important component of M-1, equals $1,000 + $800 + $640 + $512 + … = $5,000.

The multiplier in the above example, 1/required reserves, equals 1/.20, or 5. This number, as we concluded above, leads to an expansion of the nation’s money supply that is equal to five times the change in the initial deposit. The factor 5 assumes that banks’ reserve requirements are 20%. If the reserve requirement decreases, the money multiplier increases. If the reserve requirement increases, or if banks choose to hold onto more bank reserves on their own, the money multiplier decreases.

For most large banks, required reserves are 10% of transaction account deposits. Some required reserve ratios are as low as 3%, or even 0%, depending on the nature of the account and the size of the bank. If the reserve requirement is 10%, and if banks are fully loaned up and customers spend their entire loan and deposit all their earnings, then the money multiplier equals

Money multiplier = 1 / 10% = 1 / .10 = 10.

Video Explanation
For a video explanation of the money multiplier and changes in the nation’s money supply, please visit: