What Is the Deposit Multiplier?

The deposit multiplier is the maximum amount of money that a bank can create for each unit of money it holds in reserves. The deposit multiplier involves the percentage of the amount on deposit at the bank that can be loaned. That percentage normally is determined by the reserve requirement set by the Federal Reserve.

The deposit multiplier is key to maintaining an economy's basic money supply. It's a component of the fractional reserve banking system, which is now common to banks in most nations around the world.

Understanding the Deposit Multiplier

The deposit multiplier is also called the deposit expansion multiplier or the simple deposit multiplier. It's connected to the portion of a bank's deposits that can be lent to borrowers. This lending activity injects money into the nation's money supply and supports economic activity. Essentially, the deposit multiplier is an indicator of how banks can increase or multiply deposits.

Central banks, such as the Federal Reserve in the United States, establish minimum amounts that banks must hold in reserve. These amounts are known as required reserves. Banks must maintain reserves apart from what they loan to ensure that they have sufficient cash to meet any withdrawal requests from depositors. The Fed pays banks a small amount of interest on their reserves, which can be held at the bank or at a local Federal Reserve bank.

The deposit multiplier relates to the percentage of funds in reserve. It provides an idea of how much money banks could create based on what they have to lend after accounting for reserves.

Deposit Multiplier Calculation

The deposit multiplier is the inverse of the percentage of required reserves. So if the reserve requirement is 20%, the deposit multiplier is 5. Here's how that's calculated: Deposit multiplier = 1/.20 Deposit multiplier = 5 For every $1 a bank has in reserves, it is able to increase deposits (and, theoretically, the money supply) by $5 through what it lends.

The amount that a bank can lend from its checkable deposits—demand accounts against which checks, drafts, or other financial instruments can be negotiated—depends on the Fed's reserve requirement. This is fractional reserve banking at work. If the reserve requirement is 20%, the bank can lend out 80% of money on deposit.

Deposit Multiplier vs. Money Multiplier

The deposit multiplier is frequently confused with the money multiplier. Although the two terms are closely related, they are are distinctly different and not interchangeable.

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 multiplier effect of all bank lending.

The deposit multiplier provides the basis for the money multiplier, but the money multiplier value is ultimately less. That's because of excess reserves, savings, and conversions to cash by consumers.