Published on Feb 07, 2025 5 min read

Deposit Multiplier and Money Multiplier: A Simplified Comparison

Money is way more than a medium of exchange; it's the lifeblood of an economy. Yet, have you ever wondered how a dollar deposited into a bank can multiply into many dollars of circulating money? However, these two are important concepts and explain this phenomenon: the deposit multiplier and the money multiplier. Although people sometimes use these terms interchangeably, they represent somewhat different shades of money creation and circulation.

Learning these concepts can unravel some of the components that constitute modern banking and monetary policy. So, let's see what it actually means, how it works, and why they are critical for economic stability and growth.

How Does the Deposit Multiplier Work?

Banks take customer deposits and use them as ammunition to make loans, increasing the money in circulation in the economy. That's the basis for the deposit multiplier. It is dependent upon the fractional reserve banking system: in its essence, banks keep only a part of the deposits that they are obliged to make. All of it is available for lending.

Suppose the central bank has now set the reserve requirement of 10%. It means that your bank has $100 in reserves and can lend out $900. When these $900 loan funds are spent and redeposited into another bank, they become a new deposit. Each bank keeps 10% of the deposit and lends the rest.

This cycle creates a chain reaction of deposits and loans. The theoretical limit of money creation can be calculated using the formula:

Maximum Money Created= Initial Deposit/ Reserve Requirement​

In this example, the $1,000 deposit can lead to a total of $10,000 circulating in the economy, assuming no money is withdrawn as cash, and all loans are redeposited. While the deposit multiplier is a powerful concept, it's important to note that it operates under idealized conditions. In reality, the multiplier effect is often dampened by factors such as individuals withdrawing cash, banks holding excess reserves, or borrowers defaulting on loans.

The Mechanics of the Money Multiplier

If the deposit multiplier focuses on how banks turn deposits into loans, the money multiplier takes a step back to look at the broader picture. It measures how the entire monetary base (physical cash and reserves) translates into the total money supply, which includes both physical currency and deposits in checking and savings accounts.

The money multiplier is represented by the formula:

Money Multiplier = Money Supply/ Monetary Base

For example, if the monetary base in an economy is $500 billion, and the total money supply is $2 trillion, the money multiplier would be 4. This indicates that every dollar in the monetary base supports $4 in the overall economy.

Unlike the deposit multiplier, which is directly tied to reserve requirements, the money multiplier is influenced by a variety of factors, including:

Cash Holdings: When people hold onto cash instead of depositing it in banks, the money available for lending decreases, reducing the multiplier effect.

Bank Behavior: If banks choose to keep excess reserves rather than lend them out, the growth in the money supply slows.

Economic Conditions: During recessions, both borrowers and lenders tend to be more cautious, which can dampen the multiplier effect.

The money multiplier captures real-world behavior, making it a more accurate reflection of money circulation than the deposit multiplier.

Key Differences Between Deposit Multiplier and Money Multiplier

At first glance, the deposit multiplier and the money multiplier might seem like two sides of the same coin, but they serve distinct purposes and operate under different assumptions.

The deposit multiplier is a theoretical construct tied to the banking system's reserve requirements. It explains how banks create money by lending a portion of deposits. However, this concept assumes a perfect system where every loan is redeposited into a bank, and no cash is withdrawn.

The money multiplier, on the other hand, reflects the actual relationship between the monetary base and the total money supply. It accounts for real-world factors like public preferences for cash, banks holding excess reserves, and economic conditions that impact lending and borrowing.

A major difference lies in their scope. The deposit multiplier is narrowly focused on the banking system and the reserve requirement's role. In contrast, the money multiplier encompasses a broader view of the economy, including both the banking sector and public behavior.

Additionally, the money multiplier tends to be lower than the theoretical deposit multiplier due to leakages like cash withdrawals, loan defaults, and banks’ conservative reserve practices. This discrepancy highlights the difference between theory and practice in money creation.

Practical Implications for the Economy

The deposit multiplier and money multiplier aren’t just abstract ideas—they have profound implications for the economy and monetary policy. Central banks use these concepts to understand and influence the money supply, which directly affects economic growth, inflation, and employment.

For instance, by adjusting the reserve requirement, central banks can manipulate the deposit multiplier. Lowering the reserve ratio allows banks to lend more, increasing the money supply and stimulating economic activity. Conversely, raising the reserve requirement tightens the money supply, which can help control inflation.

Similarly, central banks influence the money multiplier through monetary policy tools like open market operations. By injecting money into the monetary base, they can amplify the money supply, boosting liquidity in the economy.

However, these tools must be used carefully. If too much money enters circulation, inflation can erode purchasing power. On the flip side, a tight money supply can stifle economic growth, leading to unemployment and stagnation.

Understanding these multipliers helps policymakers strike the delicate balance between fostering economic growth and maintaining price stability.

Conclusion

The deposit multiplier and the money multiplier are essential concepts for understanding the intricate processes of money creation and circulation. While the deposit multiplier focuses on how banks transform deposits into loans, the money multiplier provides a broader view of how money flows and expands across the economy. In practice, these multipliers are interconnected, yet they serve distinct purposes. The deposit multiplier lays the foundation for banking operations, while the money multiplier reflects the real-world dynamics of the money supply.