The U.S. money supply includes currencies — dollar notes and coins issued by the Federal Reserve System and the U.S. Treasury — and various types of deposits held by the public with commercial banks and other custodian banks such as savings banks and credit unions. As at 30 June 2004, the money supply, measured as the sum of foreign currency and current account deposits, amounted to $1,333 billion. Including certain types of savings deposits, the money supply totalled $6.275 billion. An even broader measure was $9.275 billion. If the reserve requirement ratio is 10%, then starting with new reserves of, say, $1,000, the maximum a bank can lend is $900, because it has to keep $100 as reserves against the deposit set up at the same time. If the borrower issues a cheque for this amount in his bank A, the beneficiary deposits it with his bank B. Each new demand deposit a bank receives creates an equal amount of new reserves. Bank B will now have additional reserves of $900, of which it will have to hold $90 in reserves, so that it will only be able to lend $810. The sum of the new loans granted by the banking system as a whole in this example is ten times the initial amount of the excess reserve, or $9,000: 900 + 810 + 729 + 656.1 + 590.5 and so on. The deposit multiplier is the reciprocal value of the minimum reserves.
Thus, if the reserve requirement ratio is 20%, the deposit multiplier ratio is 80%. This is the ratio between the amount of a bank`s verifiable deposits – debt accounts on which cheques, bills of exchange or other financial instruments can be traded – to its minimum amount. Thus, if the deposit multiplier is 80%, the bank must hold $1 in reserve for every $5 it has in deposits. The remaining $4 is available to the bank to lend or invest. Banks can hold reserves beyond the requirements set by the Federal Reserve to reduce the number of verifiable deposits. If banks lent every dollar available beyond their reserve requirements, and borrowers spent every dollar they borrowed from banks, the deposit multiplier and money multiplier would be essentially the same. In practice, banks do not lend all the dollars they have. And not all borrowers spend every dollar they borrow. You can use some of the money for savings accounts or other deposit accounts.
This reduces the amount of money creation and the number of money multipliers it reflects. Until the Federal Reserve adopted an implicit inflation target in the 1990s, the money supply tended to grow faster during economic expansions than during economic downturns. The rate of increase tended to decrease before the peak of business and to increase before the trough. Prices rose during expansions and fell during contractions. This trend is not currently observed. Aggregate monetary growth rates tend to be moderate and stable, although the Federal Reserve, like most central banks, now ignores monetary aggregates in its framework and practice. A perhaps unintended result of its success in controlling inflation is that monetary aggregates have no predictive power in terms of price. Here`s how it works. The Federal Reserve requires custodian banks (commercial banks and other financial institutions) to hold a fraction of the specified deposit liabilities as reserves. Custodians hold these reserves in the form of cash in their vaults or ATMs and in the form of deposits with Federal Reserve banks. In turn, the Federal Reserves control by lending money to custodians and changing the Federal Reserve`s discount rate for these loans and through open market operations.
The Federal Reserve uses open market operations to increase or decrease reserves. To increase reserves, the Federal Reserve buys U.S. Treasury securities by writing a check drawn on itself. The Seller of the Treasury deposits the check in a bank and thus increases the seller`s deposit. The bank, in turn, deposits the Federal Reserve`s check with its district bank, the Federal Reserve, thereby increasing its reserves. The reverse order occurs when the Federal Reserve sells government bonds: the buyer`s deposits decrease and, in turn, the bank`s reserves decrease. Some banks suddenly have excess reserves of $1 million. (His deposits are unchanged, but he has $1 million more in cash.) The bank can now grant more loans. So his T account will look like this: central banks like the Federal Reserve in the U.S.
set minimum amounts that must be held by banks. This is called the reserve requirement or reserve requirement – the amount of money a bank has to lend to its customers. The bank must continually meet this minimum in an account deposited with the central bank to ensure that it has enough money to meet all withdrawal requests from its depositors. This loan will eventually be paid to others and deposited with other banks, which in turn will lend 90% of them (1 ?rr) to other borrowers. Even if a bank decides to invest in securities rather than loans, the expansion of multiple deposit creation continues, as in Figure 15.1 “Creation of multiple deposits, with a $1 million increase in reserves if rr = 0.10,” as long as it buys the bonds from someone other than the central bank. When the Federal Reserve increases its reserves, a single bank can lend up to the amount of its excess reserves, creating an equal amount of deposits. However, the banking system can lead to a multiple expansion of deposits. Since each bank lends and creates a deposit, it loses reserves to other banks, which use them to increase their loans and thus create new deposits until all excess reserves are exhausted. The monetary multiplier reflects the increased change in the money supply that ultimately results from the injection of additional reserves into the banking system. However, the monetary multiplier differs from the more basic deposit multiplier because banks tend to hold excess reserves, and bank customers tend to convert some of the verifiable deposits into savings deposits or cash.
Money that banks do not have to hold in reserve is diverted to finance loans, and borrowed funds end up in other customers` deposit accounts. The total amount of new deposits or newly created money can be entered using the money multiplier formula. Even if there were no legal reserve requirements for banks, they would retain the required netting balances as reserves with the Federal Reserve, whose ability to control the volume of deposits would not be affected. Banks would continue to hold reserves to enable them to settle fees related to transactions with other banks, to obtain foreign currency to respond to depositors` claims and to avoid a deficit resulting from imbalances in compensation. Since 1914, there has been a sustained decline in the money supply during only three cyclical contractions, each sharp after the decline in output and the rise in unemployment: 1920-1921, 1929-1933 and 1937-1938. The severity of the economic decline in each of these cyclical downturns, it is generally acknowledged, was a consequence of the reduction in the money supply, particularly for the slowdown that began in 1929, when the money supply fell by an unprecedented third. Over the past six decades, there has been no sustained decline in the money supply. The deposit multiplier is often confused with the silver multiplier.
Although the two terms are closely related, they are not interchangeable and differ significantly. The money multiplier reflects the change in a country`s money supply created by the loan of capital beyond a bank`s reserve. It can be considered as the maximum potential money creation thanks to the multiplied effect of all bank loans. The deposit multiplier is also known as a deposit expansion multiplier or simple deposit multiplier. This is the amount of money that all banks must keep in their reserves. It allows them to operate on a daily basis, reducing the risk of depleting their supplies to meet their customers` withdrawal requests. .