Social Sciences and History / Unit 14 SSH 1330 worked example, 60 to 90 seconds
The Money Multiplier: Working the Reserve Ratio
The idea
The exam gives a reserve ratio or a deposit and asks how much money the banking system can create, and the anchor's formula answers. The money multiplier is the quantity of money the banking system can generate from each dollar of reserves, equal to one divided by the reserve ratio, where the reserve ratio is the fraction of deposits a bank wishes to hold as reserves. Money is created when a bank lends part of a deposit, the borrower's payment is deposited in another bank, that bank lends part again, and so on; the sum of the deposits is the original deposit times the multiplier. The process assumes banks hold only limited reserves and lend the rest; in an ample-reserves world the chain is shorter.
In practice
Given "a reserve ratio of ten percent", the multiplier is ten. Given "a new deposit of one thousand", the system can create up to ten thousand in deposits. Given "a ratio of twenty percent", the multiplier is five. Given "banks choose to hold excess reserves", the actual multiplier is smaller than the formula. Ask what fraction is kept, then invert it.
Where people slip
The trap is multiplying the loan rather than the deposit; the chain begins with the whole deposit. The second trap is treating the formula as a law; it is a maximum that holds only when banks lend all they can.
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