Money Multiplier: How it Works the Process

Money Multiplier: How it Works The process of creating money begins with the Federal Reserve, which controls the amount of currency that enters the system (University of Rhode Island, 2004). The currency it supplies is called high-powered money, which is directly controlled by the Federal Reserve. However, this is not the money supply. The high-powered money is distributed to two places - the vaults of the banks as reserves, or the pockets of individuals and businesses as cash. Because of the nature of the banking system, banks actually create the money.

The cash held by the banks is called reserves and these reserves form the base for banks' expansion of checking accounts. When the currency held by the public is added to the deposit (checking) accounts created by the banks, the end result is the money supply. Money Supply Process: Diagram 1. SOURCE: University of Rhode Island. (2004). Money Supply: The Fed and the Creation and Control of Money. Retrieved from the Internet at: http://www.uri.edu/artsci/newecn/Classes/Art/INT1/Mac/1970s/Money.supply.html.

The money multiplier is the ratio of the stock of money to the stock of high -- powered money (University of Rhode Island, 2004). The fractional reserve system is a key piece in the money supply process. Diagram 2 below represents this system. On the left side is the Federal Reserve's supply of high-powered money that is held either as currency by the public or reserves by the banks. If the banks create demand deposit, they must hold in their vault some cash as required reserves.

These banks may also hold some excess reserves (cash they do not use to create demand deposits). The banks' ability to create money from the cash is apparent in the positive slope of the demand deposit line - a small amount of reserves becomes a bigger amount of demand deposits. Excess reserves do not appear in the money supply so any increase in excess reserves decreases the supply of money. Diagram 2: Money Multiplier SOURCE: University of Rhode Island. (2004). Money Supply: The Fed and the Creation and Control of Money.

Retrieved from the Internet at: http://www.uri.edu/artsci/newecn/Classes/Art/INT1/Mac/1970s/Money.supply.html. According to Investopedia.com (2004): "The multiplier effect depends on the set reserve requirement. So, the result of the multiplier effect can be calculated, as the amount banks initially take in divided 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, but 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 difference of $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. It is this creation of deposits that is known as the multiplier effect. The higher the reserve requirement, the tighter the money supply, which results in a lower multiplier effect for every dollar deposited.

The lower the reserve requirement, the larger the money supply, which means more money is being created for every dollar deposited." The money supply consists of coins and currency in the hands of the public, controlled by Federal Reserve, and deposits accounts controlled by the interaction of the households and companies that use money and the banks that generate money (University of Rhode Island, 2004). The Federal Reserve is the only power, however, that can alter the money supply.

Generally, when a person makes a deposit into his account at a bank, it creates a liability for the bank (University of Colorado, 2004). A liability is basically the bank's obligations, or what it owes. However, the same deposit also creates an asset for the bank. The bank now owns the value of the deposit and will make the money work for the bank, looking for a rate of return that is higher than the interest it pays on the liability. This is how banks make money.

By offering customer a return and banking services, banks pull in deposits (liabilities), which creates assets that a bank can lend out. As long as the total return on assets is higher than the payment on liabilities, the bank turns a profit. When a bank receives a deposit, it must reserve part of it with the Federal Reserve (Fed) and pay a deposit insurance premium to the Federal Deposit Insurance Agency (FDIC) (University of Colorado, 2004). Currently, the Fed's reserve requirement is 10%.

For every dollar deposited, the money supply increases by a multiple of the dollar amount deposited. Banks may not loan out all potential reserves, choosing instead to retain excess reserves. As long as deposits end up in the domestic banking system, the result is the same (University of Colorado, 2004). The money multiplier will maintain the same value, and the general increase in the money supply will be the same.

The money supply (M1) can be increased if the coins and currency in circulation or the checking account balances (demand deposit) increase. There are four ways that this can occur (University of Rhode Island, 2004): 1. The required reserve rate is lowered: The Fed can decrease the required reserve rate, which raises the multiplier effect of high-powered money (cash). The cash stays in the banks and each dollar can support more loans and demand deposits. 2.

The discount interest rate is lowered: The Fed can lower the discount rate and lower the costs for banks holding low excess reserves, which decreases the excess reserve rate. If the Fed.