Multipliers and the Mystery of the Magic Money
This lesson printed from:
Posted August 7, 2002
Author: Lisa C. Herman-Ellison
Posted: August 7, 2002
Updated: April 21, 2008
Students learn about the purpose of the reserve requirement, how money is "created" in the economy through fractional reserves, and how the Federal Reserve uses the reserve requirement and loans to correct economic instability.
- Define inflation and explain the role that the quantity of money plays in inflation rates.
- Explain the purpose of the reserve requirement.
- Calculate the money multiplier.
- Calculate the potential money creation from a deposit, given the multiplier.
- Evaluate what the Federal Reserve should do to the reserve requirement to correct inflation or recession.
In Yugoslavia “between October 1, 1993 and January 24, 1995 prices increased by 5 quadrillion percent. This number is a 5 with 15 zeroes after it.” (Thayer Watkins, Professor of Economics at San Jose State University).
The uncontrolled creation of money causes a quick decrease in the value of currency and very rapid hyperinflation (in annual price increases of hundreds or thousands of percent), which can destroy an economy. The United States central bank--the Federal Reserve--can protect against such a calamity by controlling the supply of money. One technique the Federal Reserve uses for controlling how fast (or how slow) the money supply can grow is through a reserve requirement for bank deposits. By making changes in that reserve requirement, the Fed can “create” or “destroy” money in an attempt to prevent hyper inflation or correct serious instability in the economy. The Federal Reserve also has two other primary tools of monetary policy, the discount rate and open market operations, through which it can control the money supply.
Episodes of Hyperinflation: This San Jose State University Economics Department site describes the effects of uncontrolled growth of the money supply on hyperinflation in several nations in history.
The Federal Reserve Board: Monetary Policy: This article discusses reserve requirements.
Interactive Activity: This activity relates to monetary policy.
Read the account of Yugoslavian hyperinflation .
Although the Yugoslav economic crisis was largely caused by the physical printing of money, the uncontrolled creation of money by any means can have a devastating effect on an economy. The U.S. Federal Reserve System was created in 1913 with a primary purpose of controlling the US money supply and the value of money.
The reserve requirement is one of the most important tools the Fed uses to control the money supply. Under the reserve requirement, banks are required to hold a percentage of their deposits on account with the Fed or in their own vaults. Banks are prohibited from lending this money out to customers. In this way, the Fed puts a limit on the growth of the money supply. The Monetary Control Act of 1980 allows the Fed to set the reserve requirement at 8-14% of deposits, based on economic conditions. The reserve requirement as of February 2002 was 10% of deposits.
“Magic money” is able to grow from our fractional reserve system because money deposited at the bank is largely loaned back out to other customers. The reserve requirement places a limit on the bank’s ability to do so. For example, if Tamika enters town with $1,000 to deposit into the local bank, the bank’s actual reserves increase by $1,000. Because of the reserve requirement, those reserves will be divided into two separate funds: required reserves, which the bank must hold, and excess reserves, which the bank can lend to other customers. If the Fed sets the reserve requirement at 10 percent, the bank is required to hold on to $100 of Tamika’s deposit, and it can then lend the remaining $900 to another customer. If that customer uses the money to buy something from Mariluz, who then deposits that money back into the bank, the money supply grows to $1,900. This “magic money” is created because the sum of the same dollars are being used twice: Tamika holds papers saying that she has $1,000 in her bank account, and Mariluz holds papers saying that she has $900 in her bank account. What will the bank do with Mariluz’s $900? In accordance to the 10 percent reserve requirement, the bank must hold $90 and is free to lend the remaining $810 to another customer. This process can continue until the last penny has been loaned.
In addition to placing a limit on money creation, the Federal Reserve can make changes in the reserve requirement to try to correct problems of inflation or recession in the economy. If the economy were starting to experience serious inflation, the Federal Reserve could increase the reserve requirement, limiting the banks’ ability to lend funds and reducing the money supply. The reduced money supply would increase interest rates, making consumers and firms less likely to want to borrow funds, thereby reducing their demand for products and slowing down the economy. To see how this would work, remember that with a 10 percent reserve requirement, $10,000 could be created from an initial $1,000 deposit. Now use the interactive table to increase the reserve requirement to 12 percent. At that rate, only $8,333.33 can be created from that same deposit. The Fed can also reduce the reserve requirement to increase the money supply in the event of a recession, lowering interest rates and enticing consumers and firms to borrow more, to increase their spending. But because the reserve requirement is so powerful, the Federal Reserve Board of Governors only makes changes in the reserve requirement in case of serious economic problems.
As precise as use of the reserve requirement may seem, several factors limit its effectiveness in correcting economic problems. During a recession, reducing the reserve requirement only allows banks to make more loans available; the Fed cannot force banks to lend the money nor force consumers to take out loans. In addition, those who receive the loaned funds may choose not to redeposit those funds, holding them in cash instead. Also, money may leave the country through the purchase of imports or foreign investments, and money may enter the country through foreign purchases of our exports or investment in American assets.
Although its effectiveness may be limited by several factors, the reserve requirement remains the most powerful single tool in the Federal Reserve’s arsenal to combat economic instability. More importantly, the reserve requirement stands as one important protection against the hyperinflation that has seriously crippled economies around the world.
For extra practice in calculating the federal reserve requirements, money multipliers, and evaluating what the Federal Reserve should do to the reserve requirement to correct inflation or recession complete the interactive activity.
Because of the potential for hyperinflation, the Federal Reserve uses reserve requirements to limit the growth of the money supply. If the Board of Governors sees inflation as a serious economic problem, the reserve requirement can be increased to further limit the ability of banks to make loans and create money. The Fed can also reduce the reserve requirement, to make more money available to stimulate the economy during a recession. While some factors limit its effectiveness, the reserve requirement remains a very powerful tool of the Federal Reserve. For more information Read The Federal Reserve Board: Monetary Policy .