The Money Multiplier

September 3, 2012

I was asked to elaborate more on the fractional reserve system for completeness sake. So, I will continue on with that first as it the fundamental method of banking in today’s banking systems. The fractional reserve system is a method in banking where a banks holds ‘reserves’ in order to satisfy sudden withdrawals from its customers. In other words, not until a few decades ago, your bank was not obliged to hold the money that you deposited in its vault and in many other countries this still holds true.

In Canada, Sweden or in England for example, your funds at any account may not be there at all at any given moment. The banks in those countries are not required by law to keep your money in neither their vaults, their respective central banks nor as a ‘reserve ratio’ of their total deposits i.e. liabilities. Instead, it is lent out to customers in a variety of forms. However, banks have learned over the past that it is generally a really good idea to keep some sort of reserves as a function of their deposits.

That function in turn results in a ratio that is used to measure how much of a bank’s total deposits are in reserves. The reserve ratio acts as a first line of defense in case of a sudden upsurge of customers’ withdrawals. This is how the idea of banks artificially inflating the money supply works; Imagine you have deposited € 10 in your bank account, the bank may turn around and lend € 9 to another customer, leaving 10% of that in its vaults.

That customer then goes and deposit the loan into her bank. Her bank then lends 90% of that €9 out.. and it goes on creating the so called money multiplier effect where the original €10 that was deposited can end up to be €100 of artificially created money. Wikipedia has an elaborate example with tables, there.

The money multiplier effect is regarded by many as an unfortunate byproduct of the modern banking systems that encourages commercial banks to consistently issue new loans to stimulate economic growth. It can also either exacerbates or lessen the effects of monetary policies. Either way, fractional reserves are maintained by banks in order to avoid defaulting on their obligations or else the money multiplier effect would have no bounds and money creation would be a power law.