Friday, May 28, 2010

The Money Multiplier

Yesterday, Mrs. P linked to this article stating that the money supply is shrinking, but it was all Greek to her.

I'll explain this very simply. There this thing called the money multiplier. It works like this:

When you deposit money in a bank it's credited to your account. You put in $100, and you have $100. But the bank then lends out some portion of that money to somebody else. Let's say they lend out $75. It's not like they deduct that from your account, but somebody else has $75. So, the bank created money. That's how the fractional reserve banking system works.

The name fractional reserve comes from the idea that the bank needs to keep some fraction of the money they take in as reserves in case people want that money. In this case, the bank kept 1/4 of the money.

Well, the money multiplier works like this (it's a relatively complicated piece of math, so just trust me) you take the reserve requirement and inverse it. So, if you have a reserve requirement of 1/4, as the example above has, then any new money added to the system is multiplied by 4 when it runs through the banking system. If you only had to keep $20 of the $100, or 1/5, then the multiplier effect would be 5.

So, in light of the current situation where politicians and policy makers, as well as bank executives, are fretting about the solvency of banks and argue that they need to keep higher reserves and people are afraid to borrow and lend, it makes perfect fucking sense why the amount of money is shrinking so fast. You keep a higher proportion in reserve and the multiplier goes down. In fact, in my intro macroecon class, my professor said that policymakers are usually very hesitant to mess with reserve requirements precisely because a small change has such profound impacts.

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