Money Multiplier

In monetary economics, a money multiplier is one of various closely related ratios of commercial bank money to central bank money under a fractional-reserve banking system. Most often, it measures the maximum amount of commercial bank money that can be created by a given unit of central bank money. That is, in a fractional-reserve banking system, the total amount of loans that commercial banks are allowed to extend (the commercial bank money that they can legally create) is a multiple of reserves; this multiple is the reciprocal of the reserve ratio, and it is an economic multiplier.

In equations, writing M for commercial bank money (loans), R for reserves (central bank money), and RR for the reserve ratio, the reserve ratio requirement is that the fraction of reserves must be at least the reserve ratio. Taking the reciprocal, which yields meaning that commercial bank money is at most reserves times the latter being the multiplier.

If banks lend out close to the maximum allowed by their reserves, then the inequality becomes an approximate equality, and commercial bank money is central bank money times the multiplier. If banks instead lend less than the maximum, accumulating excess reserves, then commercial bank money will be less than central bank money times the theoretical multiplier.

In the United States since 1959, banks lent out close to the maximum allowed for the 49-year period from 1959 until August 2008, maintaining a low level of excess reserves, then accumulated significant excess reserves over the period September 2008 through the present (November 2009). Thus, in the first period, commercial bank money was almost exactly central bank money times the multiplier, but this relationship broke down from September 2008.

As a formula and legal quantity, the money multiplier is not controversial – it is simply the maximum that commercial banks are allowed to lend out. However, there are various heterodox theories concerning the mechanism of money creation in a fractional-reserve banking system, and the implication for monetary policy.