Question

Describe fractional reserve banking and how it leads to the money multiplier. Describe the meaning of and reconcile the relationship between the following two equations describing money multiplication: 1) k = RR/Deposits and 2) mm = M/H.

Answer 1

Fractional reserve banking refers to a system where only a fraction of bank deposits are backed by actual cash on hand and available for withdrawal. This is done to theoretically expand the economy by freeing capital for lending. Banks are usually required to keep on hand and available for withdrawal a certain amount of the cash that depositors give them. If someone deposits $100, the bank cannot lend out the entire amount and on the other hand banks are not required to keep the entire amount on hand: Most are required to keep 10% of the deposit, referred to as reserves. This requirement is set by the Federal Reserve and is one of the central bank's tools to implement monetary policy. Increasing the reserve requirement takes money out of the economy, while decreasing the reserve requirement puts money into the economy.

Suppose a bank has $500 million in assets, it must hold $50 million, or 10%, in reserve. As per the multiplier equation it provides an estimate for money created with the fractional reserve system and is calculated by multiplying the initial deposit by one divided by the reserve requirement. Using the example above, the calculation is $500 million multiplied by one divided by 10%, or $5 billion. This is not how money is actually created but only a way to represent the possible impact of the fractional reserve system on the money supply. As such, while is useful for economics professors, it is generally regarded as an oversimplification by policymakers.

Here K = RR / deposits means the deposit multiplier. The deposit multiplier is the maximum amount of money a bank can create for each unit of reserves. The deposit multiplier is normally a percentage of the amount on deposit at the bank. The deposit multiplier requirement is key to maintaining an economy's basic money supply. Reliance on a deposit multiplier is called a fractional reserve banking system and is now common to banks in most nations around the world.

And MM = M/H is the money multiplier where is M is the broad money and H is the base money. This is the multiplier effect refers to the proportional amount of increase, or decrease, in final income that results from an injection, or withdrawal, of spending.

There is a relationship between these two equations as they are not interchangeable and are distinctly different. The money multiplier reflects the change in a nation's money supply created by the loan of capital beyond a bank's reserve. It can be seen as the maximum potential creation of money through the multiplied effect of all bank If banks loaned out every available dollar beyond their required reserves, and if borrowers spent every dollar they borrowed from banks, the deposit multiplier and the money multiplier would be essentially the same. In practice, banks do not lend out every dollar they have available. And not all borrowers spend every dollar they borrow. They may put into some of the cash to savings or other deposit accounts. That reduces the amount of money creation and the money multiplier figure that reflects it.