Multiplier and the Mystery of the Magic Money

By Lisa Herman-Ellison

econoedlink.org. 23 Mar 2009http://www.econedlink.org/lessons/index.php?lesson=348&page=teacher

Objectives Define inflation and explain the rate 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.

Introduction 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.

Introduction 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.

Introduction 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.

Activity Read: “The Worst Episode of

Hyperinflation in History: Yugoslavia 1993-94”

Federal Reserve System 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.

Federal Reserve System 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.

Federal Reserve System 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.

As of 1/1/09 Reserve Requirement: $0 to $10.3 million = 0% More than $10.3 to $44.4 million = 3%      More than $44.4 million = 10% (“Reserve Requirement”)

Federal Reserve System “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 increased by $1,000.

Federal Reserve System Because of the reserve requirement, those

reserves will be divided into two separate funds: Required reserves – which the bank must hold Excess reserves – which the bank can lend to

other customers. If the Fed sets the reserve requirement at

10%, the bank is required to hold onto $100 of Tamika’s deposit, and it can then lend the remaining $900 to another customer.

Federal Reserve System 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% 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.

Federal Reserve System 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.

Federal Reserve System 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 with a 10% reserve requirement, $10,000 could be created from an initial $1,000 deposit.

Federal Reserve System 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.

Federal Reserve System 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 the use of the reserve requirement may seem, several factors limit its effectiveness in correcting economic problems.

Federal Reserve System 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 out exports or investment in American assets.

Federal Reserve System 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.

Conclusion 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.

The Multiplier

The size of the multiplier, 1/(1 − MPC), depends on the marginal propensity to consume, MPC: the larger the MPC, the larger the change in real GDP for any given autonomous (independent) increase in aggregate spending.

Multiplier Formulas and Terms

MPC = ∆ in consumption divided by ∆ in income

MPS = ∆ in savings divided by ∆ in income

Final outcome for (GDP): Multiplier = 1/(1 MPC) Potential GDP income = Multiplier x income

(deposit)

Activity Calculate the federal reserve

requirement, money multipliers, and evaluate what the Federal Reserve should do to the reserve requirement to correct inflation or recession.

Activity1. If the reserve requirement is 20% and a

$1,000 deposit was made in the bank, how many dollars of the deposit must the bank hold in required reserves?

2. If the reserve requirement is 20% and a $1,000 deposit is made in the bank how many dollars of the deposit can the bank lend back out to a customer?

3. If the reserve requirement is 20% and a $1,000 deposit is made in the bank, what is the multiplier (1/(1-MPC) or 1/MPS?

$200

$800

(1/0.20) = 5

Activity4. If the reserve requirement is 20% and a

$1,000 deposit is made in the bank, how much money potentially can be created from the initial deposit (multiplier x income)?

5. If the reserve requirement is 5% and $1,000 deposit is made in the bank, how many dollars of the deposit must the bank hold in cash?

(5 x $1,000) = $5,000

$50

Activity6. If the reserve requirement is 5% and

$1,000 deposit is made in the bank, how many dollars of the deposit can the bank lend back out to a customer?

7. If the reserve requirement is 5% and $1,000 deposit is made in the bank, what is the multiplier?

$950

(1/0.05) = 20

Activity8. If the reserve requirement is 5% and

$1,000 deposit is made in the bank, how much money potentially can be created from the initial deposit?

9. If the Fed is trying to reduce the inflation rate, should the Fed increase or decrease the money supply?

$1,000 x 20 = $20,000

Decrease

Activity10. If the Fed is trying to reduce the inflation

rate, should the Fed increase or decrease the reserve requirement?

11. If the Fed is trying to reduce the inflation rate, will this policy result in higher or lower interest rates?

Increase

Higher

Activity12. If the Fed is trying to reduce the inflation

rate, will this policy lead consumers and firms to borrow more or less?

13. If the Fed is trying to reduce the inflation rate, will this borrowing change lead consumers and firms to buy more or less?

Less

Less

“Reserve Requirement”. Federal Reserve Board, The. 25 Mar 2009. http://www.federalreserve.gov/monetarypolicy/reservereq.htm