The Money Multiplier

Daniel Penrod
August 4, 2009 | COMMENTS

Is it possible to actually create money (beyond the Treasury's printing of it)? Economics says it is. It's called the money multiplier. While most think of this as merely economic jargon, a large portion of the U.S. learns about it every Christmas. In the holiday classic “It's a Wonderful Life,” there is a run on the Bailey Savings and Loan where depositors try to withdraw their balances in full.

It is at this point that Jimmy Stewart's character teaches this economic lesson: “You're thinking of this place all wrong. As if I had the money back in a safe. The money's not here. Your money's in Joe's house. . . . And in the Kennedy house, and Mrs. Macklin's house, and a hundred others.” In its simplicity, that is the money multiplier.

The money multiplier is a simple equation based on the Federal Reserve Board (FRB) designated reserve ratio—the percentage of deposits an institution is required to keep on hand for its customers. For most institutions, anything beyond the required reserve is loaned out or invested.

For example, a 10 percent reserve ratio could turn $20,000 into more than $178,000. Suppose Member A takes a $20,000 loan to purchase a used car from Member B. Member B then deposits that money back into the credit union. The 10 percent reserve ratio means the credit union can now loan out $18,000 of it. The same thing happens with that $18,000, so the credit union can loan out $16,200 of that money. In two simple transactions, that original $20,000 has become $54,200.

By the 20th circuit of this money, more than $178,000 is recognized by the system. Unfortunately, this multiplier also works in reverse. When dollars are removed from the system, or if the reserve ratio is increased, the multiplier amplifies the amount of money pulled from the system or less money can be lent out. When this happens, we see contraction, less lending, and suffering in the overall economy.

In March, NCUA representatives estimated that the removal of funds from credit unions would have a 10:1 effect ratio (translating to a $10 loss in the available lending pool for every $1 taken from credit unions). With the corporate stabilization actions pulling hundreds of millions of dollars from credit union net worth and capital (equating to a loss of billions from the lending pool), the true brunt of these actions may be felt most by members who are in need of funds but finding the well depleted.

Daniel Penrod is an industry analyst for the California and Nevada Credit Union Leagues. This article was reprinted with permission from Credit Union Digest, the publication of the California and Nevada Credit Union Leagues.