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The Banking System

The Money Multiplier in Practice

The money multiplier describes the amount of money added to the circulating money supply by the lending of excess reserves in an economy.

The money multiplier represents the total amount of available capital loaned out by banks from their excess reserves and then spent by borrowers. But there is an important distinction between the mathematical function for the money multiplier and the money multiplier in practice. The mathematical function represents the maximum potential amount that would be added to the money supply if banks loaned out the entirety of their excess reserves and all that money was then spent by borrowers. In practice, banks frequently do not lend all of their the excess reserves in order to maintain greater reserves than required. Additionally, any portion of the excess reserves taken out by borrowers in the form of currency does not add to the overall money supply. Nor do funds transferred into savings accounts instead of being spent. Therefore, while the mathematical function for the money multiplier and the money multiplier in practice are close in value, the money multiplier in practice is always less than the value of the mathematical function.

The distinction between the money multiplier in practice and the value of the mathematical money multiplier has profound implications for economic policy as instituted by a central bank such as the Federal Reserve. When banks keep their excess reserves low by lending out close to the maximum allowable amount, then the money multiplier in practice and the value of the mathematical function will be close to equal. In this situation, a central bank can reliably increase the circulating money supply by injecting funds directly into banks' reserves, which will then be lent out at nearly the maximum ratio allowed. Similarly, by withdrawing funds from banks' reserves, a central bank can limit lending.

However, when banks hold onto a significant portion of their excess reserves and do not lend that money out, the power of a central bank to influence the money supply is limited to one direction. The central bank can still curtail loans by withdrawing funds, but adding funds cannot force a bank to make more loans. Sometimes adding funds can amplify already high levels of excess reserves because banks simply hold onto the additional funds. Banks will curtail lending when they feel the economic climate is too volatile or depressed to make new loans or investments. This can lead to a self-perpetuating cycle of economic slowdown. Such was the case in the financial crisis of 2007–08. A financial crisis is a spiraling downturn in the economy, during which the value of assets and the strength of the economy falls rapidly. Near the beginning of the crisis, the total excess reserves of the U.S. banking system grew from under $2 billion in mid-2008 to over $2 trillion in 2017.

Accumulation of Excess Reserves

Following the 2007-08 financial crisis, excess reserves accumulated in American financial institutions. The Fed increased the money supply but banks held onto the money and didn't loan it out. This causes their excess reserves to increase dramatically. This accumulation caused problems for the Federal Reserve, especially as the economy has recovered and excess built up further, because it had to pay interest on these reserves.