The expansion of a country's money supply that results from banks being able to lend. The size of the multiplier effect depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is money used to create more money and is calculated by dividing total bank deposits by the reserve requirement.
The relevant policy question is whether this variation is sufficiently predictable for policymakers to rely on. One way of assessing predictability is to focus on time-series properties of the multiplier and its component. Specifically, it requires analysing the behaviour of the mean and variance of these multiplier components over time, and whether these are stable around a trend. Absolute stability, in this sense, implies predictability, at least in the absence of large scale structural change. An alternative perspective on predictability recognizes that the multiplier and its components may not be stable unconditionally, but may be a stable function of other variables or of their own past values, or both. Here the relevant gauge is the ability of the authorities to predict with reasonable accuracy the evolution of the multiplier over some horizon.
A restrictive monetary policy is a decision by the Fed to raise interest rates in order to slow the growth rate of GDP. In 1994, the Fed raised the Fed funds rate seven times in order to achieve a soft landing for the U.S. economy. When open market operations are used to implement a restrictive monetary policy, the Fed sells bonds to banks. By purchasing bonds from the Fed, banks have less money to loan out and the monetary base shrinks. The result is a reduction in the money supply by a factor of the money multiplier. The reduction in the money supply and bank reserves raises the Fed funds rate using the opposite of the process described above. As long-term interest rates increase along with the Fed funds rate, business investment and consumer borrowing both decrease, resulting in slower GDP growth.
One important feature of tins model is that it decomposes movements in the money supply into the part that is due directly to Federal Reserve policy actions (the adjusted monetary base) and the part that is due to changes in technology and the tastes and preferences of depository institutions and the public (the money multiplier). In this decomposition, the multiplier is assumed to be independent of the policy actions of the central bank. The independence is implicitly predicated on the assumptions that the demands for both checkable deposits and currency are determined by the same factors, and that individuals can quickly and costlessly alter their holdings of currency and checkable deposits to achieve the desired proposition of the two alternative forms of money.
The money multiplier framework has a long and distinguished pedigree in the literature.1 Multiplier analysis is based on the assumption that the central bank unilaterally sets the level of the monetary base, i.e. the monetary base is the instrument of monetary policy. The money multiplier then determines the supply of broad money, while short-term interest rates adjust in order to establish equilibrium between money demand and money supply. Clearly, this account contrasts with the way in which monetary policy is, in general, implemented in practice. In fact, as noted in the main text of this article, central banks set an official interest rate and then supply the volume of reserves necessary in order to steer short-term market interest rates close to the official interest rate.
The money multiplier defines the relationship between the money supply and the monetary base, and is usually defined as the ratio of M3 to M0. The behaviour of the money multiplier has changed dramatically in recent years. For the hundred years starting in 1870, it was relatively stable, fluctuating within fairly narrow limits until about 1970. Since then it has more than doubled in magnitude and, in the 1980s, M3 has continued to outgrow M0 by a large margin. During the last ten years the demand for cash by the public has fallen and the demand for bank deposits has increased. The private sector has made greater use of the banks because they have offered interest rates on sight deposits in order to attract business. As intermediaries, banks have expanded their assets, and bank lending has increased because of shifts in supply rather than in demand. At the same time, banks have been able to lower their cash reserves and expand their lending. Thus, for a given volume of base money (M0), broad monetary aggregates have grown disproportionately because the money multiplier has increased.
The two main official measures of money in the United States are M1 and M2.
M1 consists of currency outside banks, traveler’s checks, and checking deposits owned by individuals and businesses.
M2 consists of M1 plus time deposits, savings deposits, and money market mutual funds and other deposits.
The multiplier model of the money supply, originally developed by Brunner (1961) and Brunner and Meltzer (1964), has become the standard paradigm in macroeconomics and money and banking textbooks to explain how the policy actions influence the money stock. It has also been used in empirical analyses of money stock control and the impact of monetary policy actions on other economic variables. In monetarist analysis, the interaction of the supply of money - or its inverse, the velocity of circulation of money, forms the basis of models of price and/or exchange rate determination. The multiplier model of the money supply argues that the control of the money supply relies on the authorities being able to control the base and to predict behavioral relations of the banks and the non-bank private sector.
The multiplier effect depends on the set reserve requirement. So, to calculate the impact of the multiplier effect on the money supply, we start with the amount banks initially take in through deposits and divide this by the reserve ratio. If, for example, the reserve requirement is 20%, for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend out the remaining $64. This cycle continues - as more people deposit money and more banks continue lending it - until finally the $100 initially deposited creates a total of $500 ($100 / 0.2) in deposits. This creation of deposits is the multiplier effect.
Under the fractional reserve banking system, a unit of cash injected into the system by a central bank increases as it propagates through the banking system. Thus an increase in the monetary base has a magnified effect on the money supply and the multiplicative effect is represented by the money multiplier.