The Money Multiplier

Banks are required to hold only a fraction of each deposit as reserves and can lend out the rest. When that loan gets spent and redeposited in another bank, that bank also keeps a fraction and lends out the rest. Round after round, a single deposit ripples through the banking system, with each new loan adding to the money supply. The size of this effect is captured by the money multiplier, equal to 1 divided by the required reserve ratio. Multiply it by the initial new deposit to get the maximum possible increase in the money supply.

The process is self-limiting, not limitless. Every round, required reserves get pulled out of circulation before the rest is lent again, so each successive loan is smaller than the one before it. The amounts form a shrinking geometric sequence that converges to a finite total rather than growing forever. A lower required reserve ratio means banks hold back less each round, so more gets re-lent each time and the multiplier is larger; a higher ratio shrinks the multiplier.

This sits right next to the idea of the money market, where the nominal interest rate is set by the supply and demand for money that this multiplier process helps determine. A bigger multiplier means a given open market purchase by the central bank shifts the money supply curve further, which is why the multiplier matters for understanding monetary policy's reach before moving on to how that nominal rate interacts with the real rate in the loanable funds market.