Multiplier Effect: How Fractional Reserve Banking Creates Money ?

The modern banking system is considerably different from what the average person believes it to be. Banks are not institutional moneylenders. They do not simply collect money from people and lend them to others. Instead, banks in the modern world have the power to create money when they lend it out. The process by which this happens is called fractional reserve banking.

Under a fractional reserve banking system, banks can expand the total money supply of the system by several times. This expansion of money supply is called the “multiplier effect” and we will study it in detail in this article.

Base Money

The process begins with a certain amount of base money. In old times, this base money used to be gold pieces. However, in the modern times, reserves kept at the central bank form this base money. This is often referred to as M0 by the economists. This is also the amount of money that exists in the form of physical bank notes and coins. Therefore, at any given point in time, this is the money that has actual physical existence.

How Much Money Can be Created ?

The central banks all over the world have a reserve requirement. This means that at every step of the process, they have to deposit let’s say 10% of their deposits with the central bank whereas the rest can be used to create bank loans.

When the remaining 90% of the money is loaned out, new money is created. This money exists in addition to the already existing deposits on the bank ledgers. However, in reality it does not exist.

Therefore, if a bank had $100 in deposits, they kept $10 in reserves and lent out $90 dollars, the total money supply in the system went up to $190 dollars. Also, the $90 is a new deposit. It can once again be used by the banks wherein they keep $9 in reserves and lend out $81. Once again, the $81 will be a new addition to the total money supply. Hence, the total money supply would now increase from the original $100 to the new $271.

Notice that the amount of base money i.e. the money that has physical existence remains the same i.e. $100 whereas the amount of money in the checking accounts of people is increasing. This amount of money that people have in their checking accounts is what the economists call M1.

Now, that it has been ascertained that fractional reserve banking allows banks to create more money while they make loans, the question arises as to how much money can be created in the system at any given time. This is determined by the reserve requirements that are set by the central bank.

For instance, if the reserve requirement is 10%, then the total amount of money that can possibly be created is given by the concept of money multiplier.

The reserve ratio can be used to compute the money multiplier by using the following formula.

Money Multiplier = 100/Reserve Ratio

In this case, the money multiplier is 10. If the reserve ratio was 8%, then the money multiplier would have been 12.5

Now, to determine the total amount of money that can possibly be created, we need to multiply the base money with the money multiplier. Hence, when the reserve ratio is 10, the original $100 of base money can be multiplied to $1000. On the other hand, if the reserve ratio changes to 8%, the original $100 of base money can create $1250 in M1.

Controversy Regarding Multiplier Effect

The multiplier effect is probably the characteristic feature which defines fractional reserve banking. It is also the feature which faces the most criticism. This is because many people believe that the multiplier effect allows banks to artificially create deposits and collect interest on money which they do not have! This allows them to siphon larger and larger sums of money from the general population into their own pockets. Hence, even though the money that they create is extinguished when the loan is repaid, they get to collect interest on the money that they did not have in the first place!

Secondly, the money multiplier effect creates a massive amount of inflation. When the money supply of any economy goes up by 10 to 15 times over a given period of time, obviously the prices tend to rise as well. Hence, the multiplier effect if against the basic goal of financial stability that is pivotal for the existence of central banks.

Also, fractional reserve banking creates a perpetual danger of a bank run. The banks only have 10% of the amount of money for which they have issued IOU’s. The only reason why banks survive is because depositors do not show up at the same time to demand their funds. If they did, the entire banking system would collapse.

The fractional reserve system and the multiplier effect are extremely important for anyone trying to understand modern banking. This system has undergone massive change in the past century.

Banks used to maintain as much as 60% of their deposits in reserves. However, nowadays banks hold close to 6% in reserves. Thus the amount of money being created has reached unprecedented heights in the recent years. Only time will tell how this modern banking system plays out in the long run.