Economics Part A

Deposit Multiplier and Loan Multiplier

Deposit Multiplier

The deposit multiplier is a number that determines the amount of demand deposits that the bank can handle for each $1 deposited in the vault. If the deposit multiplier is 4, than the bank can hold $4 in bank account deposits for each $1 in the vault.

The Relationship between the Reserve Ratio and the Deposit Multiplier

These are both reciprocals of each other. As can be seen in the previous tables:

  • The deposit multiplier for bank A is 2 and the reserve ratio is 1/2 (0.5).

  • The deposit multiplier for bank B is 5 and the reserve ratio is 1/5 (0.2).

     

     

    The Loan Multiplier

    The loan multiplier determines the amount that a bank can lend for each $1 in its vault. If the loan multiplier is 3, that means that the bank can lend $3 for each $1 that is in its vault. If the bank has cash of $2,000, the bank can make loans of up to $6,000.


    The Relationship between the Loan Multiplier and the Deposit Multiplier (or the Reserve Ratio)

    The connection will be demonstrated with an example in which the deposit multiplier in Bank A is 4 (or reserve ratio is 0.25). In this example, the balance sheet of Bank A looks is as follows (small numbers are used for the sake of simplicity).


    Assets

    Liabilities

    Cash                                       $1

    Deposits                                $4

    Loans                                     $3

    Equity Capital                       $0

    Total                                      $4

    Total                                      $4

    It can be seen that the loan multiplier is 3 (1 less than the deposit multiplier). Explanation: In order to obtain deposits of $4, the bank must lend $3.

    If the deposit multiplier for Bank A were 10, its balance sheet would be as follows:


    Assets

    Liabilities

    Cash                                       $1

    Deposits                                $10

    Loans                                     $9

    Equity Capital                       $0

    Total                                      $10

    Total                                      $10

    The Reserve Ratio and its Impact on the Level of Risk

    For example, a 0.1 reserve ratio means that if all the depositors want to withdraw their money simultaneously, they can receive only 10% (1/10) of it (the reserve ratio). For each $1 in the bank vault, they deposited $10.

    The lower the reserve ratio (or the higher the deposit multiplier) the higher the risk.

     

Deposit Multiplier and Loan Multiplier 525Deposit Multiplier and Loan Multiplier