Why the Multiplier Overstates Expansion

The textbook multiplier, 1 divided by the required reserve ratio, tells you the biggest possible increase in the money supply a new deposit could ever trigger. It assumes two things that almost never hold perfectly: that banks lend out every cent of excess reserves, and that borrowers redeposit all the cash they receive instead of holding any of it outside a bank. Each lending round is supposed to shrink by exactly the required ratio and nothing more.

In practice, two leaks shrink every round further than the formula expects. Banks often choose to hold excess reserves beyond what regulation demands, as a cushion against withdrawals or because loan demand looks weak, and that money never gets lent out at all. Separately, when loans get made, some of the cash gets held by the public as currency rather than redeposited, so it drops out of the reserve-lending chain entirely. Both leaks mean each round of lending creates less new money than the pure required-ratio math predicts.

This matters because it connects the mechanical deposit-expansion story to the real money market. The actual money supply curve reflects these realistic, smaller expansions, not the theoretical maximum. It also sets up why central bank tools like reserve requirements or interest on reserves can shift behavior: banks deciding to sit on reserves instead of lending is itself a policy-relevant choice, not a fixed mathematical outcome.