What is the credit multiplier effect?

At its core, the credit multiplier effect refers to the amplification of initial deposits through a series of loans and re-deposits within the banking system due to its’ fractional reserve nature. This phenomenon has a cascading effect, where every dollar deposited in a bank can multiply into several dollars in the economy.

So what is fractional reserve lending?

Here’s how it works:

1. Initial Deposit: Imagine you deposit $1000 in your local bank.
2. Reserve Requirements: Banks are obligated to hold a fraction of deposits in reserve, as mandated by the central bank. Let’s assume the reserve requirement is 10%.
3. Loan Creation: With a 10% reserve requirement, the bank can lend out $900 of your initial deposit ($1000 – 10% reserve).
4. Multiplier Effect: The borrower then spends the $900, which eventually gets deposited in another bank. Following the same 10% reserve requirement, this bank can lend out $810.
5. Continued Cycle: This process continues, with each new deposit creating more loans and expanding the money supply.

Key Implications:

1. Economic Growth: The credit multiplier effect stimulates economic activity by making more funds available for investments, businesses to create jobs, and consumer spending.
2. Inflation: Central banks use the credit multiplier effect in conjunction with interest rates to influence the money supply. By adjusting reserve requirements, they can affect borrowing costs and, consequently, spending and investment patterns. Which helps them influence inflation.
3. Financial Stability: While the credit multiplier effect fosters economic growth, it also poses risks. If not managed prudently, excessive lending can lead to financial instability or inflation. Increasing the reserve requirement is a way of limiting the leverage in the financial system.

This is also known as fractional reserve lending or the fractional reserve system.

The credit multiplier formula can be expressed as follows:

Credit Multiplier=1/Reserve Requirement Ratio

For example, with a reserve requirement ratio of 10%, the credit multiplier would be 1/0.1=10

This means that an initial deposit of $1,000 can theoretically generate $10,000 in the economy.

See also:

What is inflation?

What is the role of the Central Bank?

What is the Money Supply?

Why do interest rates change over time?