The deposit creation multiplier

Consider an initial deposit at a commercial bank. Because of this deposit (called a primary deposit), the bank is holding currency. To make a profit for its investors, the bank loans this money out. The person that gets the loan spends the money which will eventually be deposited in a bank. This second deposit is referred to as a derivative deposit or secondary deposit. Any of these additional derivative deposits increase the amount of the money supply.

Some governments (or their central banks) restrict the proportion of primary deposits that can be lent out. This is called the cash reserve ratio . For example, lets assume that a primary deposit of $1000 is made into bank A. If the cash reserve ratio is 12%, then $120 must be kept on hand by the bank and $880 is available to be lent to someone else (called the excess reserve). Now if bank A uses its $880 in excess reserve by lending it out, and that is deposited in bank B, it represents a primary deposit to the second bank. Bank B must keep 12% of $880 on hand but can lend out $774.40. If that $774.40 is eventually deposited in bank C, the third bank must keep $92.93 on hand but can lend out $681.47. The process continues until there is no excess reserve left (For simplicity we will ignore safety reserves.). By adding all the derivative deposits we can calculate the amount of money created. Alternatively we can use the deposit multiplier equation:

TD = ID / crr where TD=change in Total Deposits ID=Initial change in Deposit crr=cash reserve ratio

The initial change in deposit of $1000 will increase total deposits by $7333.33 given a reserve ratio of 12% (1000/.12=8333.33).

In actual fact, the money creation multiplier is more complex than this simple description. We must add to the equation the currency drain ratio (the propensity of the public to hold cash rather than deposit it in the banking system),the clearing house drain (the loss of deposits from the system due to interactions between banks), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold - usually a very small amount). Also, most jurisdictions require different levels of reserves for different types of deposits. Foreign currency deposits, domestic time deposits, and government deposits often have different reserve ratios.

The USA is an example of a nation where the central bank regulates cash reserve ratios. Australia and New Zealand are examples of nations where there is no such regulation.

Note: current reserve ratio is 10 percent

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