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Lesson M05.L05: Money Creation: Reserves, Deposits, and the Money Multiplier

Module: Fiscal Policy, Money, Prices, and the Reserve Bank Level: intro Duration: 30 minutes Learning Objective: Explain the money creation process through fractional reserve banking and calculate the money multiplier. Data as of: 2024 Provenance: RBA Education | OpenStax Macro 3e | Khan Academy Macro

Explanation

Modern banks operate on a fractional reserve basis — they hold only a fraction of their deposits as reserves and lend out the rest. This lending process creates new money.

Here's the key insight: when a bank makes a loan, it doesn't hand over existing cash. It creates a new deposit in the borrower's account. That deposit is new money. If the borrower spends it, the recipient deposits it at another bank, which then lends out most of that deposit too — and the cycle continues. Each round of lending creates new deposits, expanding the money supply far beyond the initial deposit.

The reserve ratio (also called the required reserve ratio, or just the reserve requirement) is the fraction of deposits a bank must keep as reserves — either as vault cash or in its Exchange Settlement Account at the RBA. In Australia, there is no statutory minimum reserve ratio for commercial banks, but banks hold reserves for prudential and liquidity reasons. For teaching purposes, we treat the reserve ratio as given.

The money multiplier tells us the maximum total increase in deposits (and thus the money supply) from an initial deposit:

Money multiplier = 1 ÷ reserve ratio

If the reserve ratio is 10% (0.10), the multiplier is 1 ÷ 0.10 = 10. An initial deposit of $1,000 can ultimately support up to $10,000 in total deposits across the banking system.

In practice, the multiplier is smaller than the theoretical maximum because banks hold excess reserves and because people hold some money as cash rather than depositing it all.

Worked Example

Scenario: The RBA injects $10,000 into the banking system. Banks operate with a reserve ratio of 20% (0.20).

Step 1 – Calculate the money multiplier: Money multiplier = 1 ÷ 0.20 = 5

Step 2 – Calculate total money creation: Maximum increase in money supply = Initial deposit × Money multiplier = \(10,000 × 5 = **\)50,000**

Step 3 – Trace the rounds of lending:

Round New Deposit Reserves Kept (20%) New Loan Made
1 $10,000 $2,000 $8,000
2 $8,000 $1,600 $6,400
3 $6,400 $1,280 $5,120
… … … …
Total $50,000 $10,000 $40,000

Step 4 – Interpret: The original $10,000 injection ultimately supports $50,000 in total deposits. The banking system has "created" $40,000 in additional money through successive lending rounds.

Conclusion: The money multiplier shows how a single injection of base money can expand into a much larger money supply through the lending process.

Common Misconceptions

Misconception 1: "Banks lend out the money that depositors put in — they need deposits before they can lend."

Correction: In the modern banking system, bank lending creates deposits — the loan comes first, then the deposit. When your bank approves a $300,000 mortgage, it simultaneously creates a $300,000 deposit in your account. This is confirmed by the RBA and the Bank of England in their publicly available education materials.

Misconception 2: "The RBA controls the money supply by controlling reserves through the money multiplier."

Correction (modern view): The textbook money multiplier is a useful teaching tool, but it does not accurately describe how monetary policy works today. In practice: - Money supply and bank lending are largely endogenous — driven by loan demand, not reserve supply - The RBA primarily sets the price of reserves (the cash rate), not their quantity - Banks can generally obtain reserves as needed from the RBA at the prevailing cash rate

This is why the RBA implements monetary policy by setting an interest rate target, not by controlling the money stock. The money multiplier model is a useful conceptual simplification, but central banks switched to interest rate targeting decades ago precisely because controlling M was found to be impractical.

Practice Prompts

  1. If the reserve ratio is 5% (0.05), what is the money multiplier? → Answer: Money multiplier = 1 ÷ 0.05 = 20. An initial deposit of $1 can support up to $20 of total deposits.

  2. A bank receives a new deposit of $50,000 and holds a 10% reserve ratio. How much can the banking system (across all rounds of lending) ultimately create in total new deposits? → Answer: Money multiplier = 1 ÷ 0.10 = 10. Total deposits = \(50,000 × 10 = **\)500,000**.

  3. Why is the actual money multiplier in Australia typically lower than the simple formula suggests? → Answer: Two main reasons: (1) Banks hold excess reserves beyond the minimum needed for prudential or liquidity reasons, which reduces lending capacity. (2) People hold some money as cash rather than depositing it all, which breaks the deposit-lending cycle and reduces the multiplier effect.

Further Resources