Banking can be a complex thing, but understanding what’s known as the simple deposit multiplier doesn’t have to be. The simple deposit multiplier is the multiple by which a bank can lend out funds based on the reserve requirements. It ensures the bank maintains the minimum amount of money on hand to keep bank operations up and running. It also gives the bank the opportunity to boost the economy.
What Is a Deposit Multiplier?
Also called the deposit expansion multiplier or simple deposit multiplier, a deposit multiplier is the maximum amount of money banks can create based on reserved units. To put it another way, it’s the multiple that banks use to know how much they can lend out vs. money kept on hand (say, in checking accounts) according to the existing reserve requirement. The deposit multiplier is typically a percentage of the amount deposited at a bank.
Why does the deposit multiplier concept matter? It plays a key role in the fractional reserve banking system, or FRB. This system involves the stipulation that banks must keep a certain amount of money on hand in reserves to conduct their day-to-day business. More specifically, the U.S. central bank, the Federal Reserve, mandates that banks hold a certain amount of money, known as required reserves, to make sure there is enough month for withdrawals from depositors. Any excess money that remains after the bank fulfills its daily operations can be loaned to borrowers (say, for mortgages). The amount that can be used for loans is determined by the deposit multiplier.
By accepting deposits and then making loans, banks have the ability to increase and decrease the money supply. When a financial institution lends out money in excess of its required reserves to businesses and consumers, it can amplify the money supply. That’s why the deposit multiplier metric matters; it’s a key way that the Federal Reserve and central banks can control the money supply as part of an overall monetary policy.
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How Does a Deposit Multiplier Work?
Here’s how a deposit multiplier works: When the account holder puts money in any of the different kinds of deposit accounts offered, the bank holds a percentage of it. This percentage is called the reserve requirement, which is set by the Federal Reserve. It helps ensure that the bank keeps an adequate amount of cash reserves available to meet the needs of withdrawal requests.
Keeping money accessible on demand can be critical. This protects against people trying to withdraw cash in keeping with fund availability rules and finding that their money is unavailable, which could be a deeply problematic and distressing experience.
A deposit multiplier is the multiple that allows banks to lend out money that’s deposited in the bank. This is the maximum amount of money the bank can lend out according to the value of its reserves. It is typically expressed as a percentage. You’ll learn more about that in a moment.
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Real Life Examples of a Deposit Multiplier
To understand a deposit multiplier, it’s wise to understand a few basic banking concepts.
• For banks, deposits are liabilities, because it is money owned by the account holder, and loans are assets for banks, because that money belongs to the financial institution and must be repaid.
• Banks also have reserves, which are deposits in the bank or in the Federal Reserve. Reserves are cash available to the bank.
◦ There is also an amount the bank must keep on hand, known as required reserves.
◦ Excess reserves is the term used to describe when the bank has more reserves than is required; these funds can in turn be lent out.
Now, if someone makes a $1,000 deposit, the bank’s liabilities and reserves would increase by $1,000. If the required reserve ratio is 10%, that means must keep $100 on hold and available, but the other 90%, or $900, may be lent. This allows the bank to expand the economy and profit.
To see how the simple deposit multiplier works, consider an example in which a deposit of $10,000 was made and the required reserve ratio is 5%, meaning $500 has to stay on hand.
The deposit multiplier formula is: 1 / reserve ratio.
So with a required reserve ratio of 20%, the deposit multiplier is five. That means that for every dollar in the bank’s reserves, the financial institution can boost the money supply by up to $5. If the reserve ratio was 5%, the deposit multiplier would be 20, and the bank could build the money supply by $20 for each dollar held in reserve. As you see, the lower the reserve ratio is, the higher the deposit multiplier is and the more it can lend out.
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How Do You Find the Simple Deposit Multiplier?
The simple deposit multiplier is a ratio between bank reserves and bank deposits. It’s important for maintaining the money supply of the economy and the banking system.
As noted above, this figure is calculated by dividing 1 by the required reserve ratio. For example, if the required reserve ratio is 10%, this means the deposit multiplier is 10. For banks, this means that for every $10 deposited, a total of $1 must be kept in reserves, and the bank can increase the money supply by $10 for each dollar it’s holding.
Deposit Multiplier and the Economy
The Federal Reserve, which is the U.S. central bank, uses the deposit multiplier as one of its monetary tools to control the supply of money in the economy. Usually the money that is deposited in a bank is unlikely to stay in the bank. The money that a consumer deposits in a bank is lent out to another consumer in the form of a loan. The deposit multiplier measures this change in checkable deposits as bank reserves change.
Banks are creating money by expanding the amount of reserves into a larger amount of deposits. If the bank decides to keep a small amount of deposits as reserves that means more money is sent to other banks and more deposits are created at these other banks. If a bank decides to keep a larger sum of deposits as reserves, that means less money or new deposits are made in other banks or circulated among consumers.
When money is loaned out to a consumer, at some point that loan will be repaid and deposited back into the banking system. If there is a required reserve ratio of 10%, then 10% of that new deposit will remain in the bank and the rest can be loaned out into the economy. This cycle fuels economic growth, not to mention profit for the bank.
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Deposit Multiplier vs Money Multiplier
While these two terms sound quite similar and are closely connected, they are not quite interchangeable. Consider the differences between a deposit multiplier vs. money multiplier.
• The deposit multiplier is the maximum amount of money banks can create by lending funds. Some deposited money must remain on hand according to the required reserve ratio, but the rest can be used to grow the economy as indicated by this figure. The deposit multiplier is calculated as one divided by the reserve ratio.
• The money multiplier is the increase in the bank’s money supply. It measures the change in money supply created through bank lending and is usually lower than the deposit multiplier since banks don’t lend all of their reserves.
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The Takeaway
The deposit multiplier is a tool used by financial institutions. It expresses the maximum amount of money a bank can create based on its cash held in reserves. The figure is calculated as one divided by the required reserve ratio; the lower the reserve ratio is, the higher the deposit multiplier is and the more a bank can lend out. The deposit multiplier can help to optimize an economy’s money supply, which is why this metric is used by central banks all over the world.
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FAQ
How do you use a deposit multiplier?
The deposit multiplier is used to determine the amount of money that can be created with the funds in a bank’s money supply.
How are deposit levels calculated?
In banking, the loan-to-deposit ratio (LDR) is calculated by dividing the bank’s total amount of loans but the sum of deposits over a specific time period. Loans are considered assets, by the way, since the money is the bank’s, while deposits are deemed liabilities, since they belong to the account holder.
What is the formula for a simple deposit multiplier?
To find the deposit multiplier, you divide one by the required reserve ratio. So if the reserve ratio is 5%, the deposit multiplier is 20. If the reserve ratio is 10%, the deposit multiplier is 10.
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