We have just seen how banks create new money when they make loans using the deposits of their customers. As money gets deposited and loaned out from banks over and over, an initial amount of money can generate new deposits and loans many times over. Just how much money can an initial deposit actually create? We can use the money multiplier to find out.

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In theory, money creation can be infinite if banks loaned out 100% of all money deposited, and all loaned money found its way back into another bank following their business transactions. But this is highly unlikely due to several factors, the most important being reserves held by the bank.

Because all banks are required to hold a certain percentage of their deposits as reserves in their vault or at their regional Fed bank, the maximum amount of money that can be created is limited by the reserve requirement.

Given a bank’s reserve requirement, the potential or maximum amount the money supply can increase (or decrease) when a dollar of new deposits enters (exits) the system is called the money multiplier. The money multiplier is defined as:

Thus, if the reserve requirement is 20%, as in our example in the previous section, the money multiplier is 1/0.20 = 5. Therefore, an initial deposit of $1,000 will create an additional $4,000 in money for a total of $5,000, a five-fold increase.

The money multiplier is important to economic policy because money can be initially deposited into the banking system in two ways. The first approach, described earlier, is a cash deposit made by a bank customer. The second approach occurs when the government injects new money into the banking system through the power it has to print money.

When the government “prints money,” it does not mean it is printing banknotes and spending it at the mall. Instead, the government typically adds reserves electronically to banks in exchange for bonds and other assets. This money did not exist before the Fed created it by just a stroke of a computer key. When these funds are added to bank reserves, that in itself increases the money supply (unlike a customer’s cash that is already counted in the money supply). Further, the effect is compounded by the money multiplier. The government therefore possesses tremendous power in influencing the money supply through its ability to print money and via the money multiplier.

But the ability of the government to expand the money supply is subjected to various factors preventing the full money multiplier from taking place. In other words, the money multiplier formula gives us the potential money multiplier. The actual money multiplier will be smaller because of leakages from the banking system. How much smaller?

The potential money multiplier and the actual money multiplier are rarely the same because of money leakages. A leakage is money that leaves the money creation process of deposits and loans due to an action taken by a bank, an individual, a business, or a foreign entity.

Bank Leakages Banks are in the business of making loans. If they don’t, they likely will not stay in business for long, especially if all they do is accept deposits and pay interest on those deposits. For any bank, profits come from the interest charged on loans made to borrowers. For this reason, it is generally presumed that banks will be loaned-up, or maximize the amount of loans they can make given the reserve requirement.

However, many banks choose not to be loaned-up. Instead, banks hold excess reserves, or reserves above the legally required amount. Why would a bank choose not to loan out the maximum amount of money allowed?

The lessons from the last financial crisis point to the answer. The recession caused many loan defaults and foreclosures as workers were laid off or faced wage cuts. Whenever a borrower defaults on a loan, the amount of that loan is removed (written off) from the bank’s assets; however, the bank still owes the people whose deposits made those funds available. Banks absorb these losses through the profits they earn from charging interest to those who pay back their loans. If a large number of borrowers default on their loans, the bank risks a solvency crisis, when its liabilities exceed its assets. This means that the bank owes more than what is owed to it, increasing the likelihood of bankruptcy.

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Returning to our earlier example, suppose that Jenna used her $300 loan to pay off her bills (transferring money from her account to her creditor’s account) but then defaults on her loan. The bank’s balance sheet would now read:

The difference between assets and liabilities is a bank’s equity, or value that is shared by the bank’s shareholders. Although equity is not a liability, it appears in the liabilities column because ultimately any gains are distributed to shareholders like a liability. When liabilities exceed assets, as in the case above, the bank has negative equity (shown as −$300 on the right-hand side of the T-account). When this occurs, the bank is insolvent; in other words, it’s broke.

To reduce the risk of a solvency problem leading to bankruptcy, banks often hold excess reserves during tough economic times to ensure that they have the ability to absorb a higher rate of defaults. Further, banks also choose to be more cautious about to whom they lend money, as they did following the last financial crisis, which led to a smaller money multiplier.

When banks choose not to loan all of their excess reserves, the actual money multiplier is reduced because the reduction in loans recirculates less money back through the banking system.

As we saw in the chapter opener, the willingness of banks to lend generates a powerful effect on the economy. We now know that this is due to the money multiplier. However, the lack of lending creates the opposite effect, which makes bank leakages an extremely important obstacle to economic growth.

Leakages by Individuals and Businesses Earlier in the chapter, we saw how holding cash reduces the ability of banks to create money. Why would people choose to hold more cash?

One factor might be the interest rate the bank pays on deposits. If interest rates paid on savings and checking accounts at the bank are near 0, as they has been for much of the past decade, one might choose to hold more savings in cash out of convenience, or make fewer trips to the bank by making larger withdrawals from an ATM. Another factor might be a general rise in fear about the financial system. Despite the existence of the FDIC, when banks are in trouble, people begin to believe that their money is less safe in banks and start to hold more cash.

When individuals choose to keep money in cash rather than deposit it in a bank, a leakage in the money supply occurs because that money is not available to be loaned to someone else. The cycle of lending and saving that would be generated from that money comes to a halt, and the actual money multiplier is reduced.

Individuals are not the only ones to hold cash. Most businesses conduct a portion of their transactions using cash. Therefore, at any one time, a business will be holding a certain fraction of its money in cash rather than in a bank. The percentage of cash holdings varies by business, but regardless represents a leakage in the money supply. As businesses hold more cash, as do individuals, this diminishes their deposits, thus reducing the actual money multiplier.

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The Effect of Foreign Currency Holdings Most Americans are accustomed to using debit and credit cards for daily transactions, reducing the need to hold cash. Yet, surprisingly, the U.S. government continues to print billions of new U.S. dollars each year. If Americans generally are holding smaller amounts of cash, who then is holding all of these dollars?

The answer is foreign consumers, businesses, and governments. Because of the relative stability of the U.S. dollar, many countries hold U.S. dollars in reserves in order to provide support to their own currencies. Some countries, such as El Salvador and Ecuador, have abandoned their own currency altogether, choosing to use the U.S. dollar as their only legal form of currency. The prominent role that the U.S. dollar plays as the world’s most popular reserve currency causes the majority of U.S. dollars (about two-thirds, in fact) to be held outside of the United States. Because of the sheer volume of U.S. currency being held as cash throughout the world, this has the effect of reducing the actual money multiplier relative to its potential. But keep in mind that this is not necessarily a bad thing. A popular currency allows the U.S. government to print more without worrying about a significant decrease in its value relative to other currencies.

Given the leakages described earlier, economists have studied and estimated the actual value of the money multiplier that ultimately influences economic growth. What they have found is that leakages in the U.S. economy tend to be large, due to significant cash holdings by foreigners and banks’ unwillingness to lend when the perceived risks of default are high.

To study the effect of leakages on the actual money multiplier, it is useful to modify our original money multiplier formula (1/Reserve Requirement) by adding the bank and cash leakages to the formula to create a leakage-adjusted money multiplier.

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A leakage-adjusted money multiplier takes into account the required reserve requirement along with excess reserves held by banks and cash held by individuals, businesses, and foreigners. Higher values of these components translate to greater leakages and therefore a lower actual money multiplier.

For example, suppose that the reserve requirement is 20%, but the existence of leakages doubles the percentage held in reserves and cash to 40%. These money leakages cause the money multiplier to drop from 5 (1/0.20) to 2.5 (1/0.40), a significant reduction in money creation in the economy.

Empirical data have shown that money leakages tend to increase during economic recessions, when banks are more reluctant to lend and people are more likely to hold cash. We will see in the next chapter that the resulting decrease in the money multiplier adds to the challenges of using monetary policy to pull the economy out of a recession.

During the 2007–2009 recession, the money multiplier fell precipitously from 1.7 to less than 1. A money multiplier of less than 1 means that fewer loans were being made than the new money introduced into the economy. This is very important because actions by the government to increase the money supply result in less bang for the buck when the money multiplier is smaller. Such an effect renders monetary policy much more challenging.

The fact that banks can create money by making loans represents a great deal of power. This power is mitigated by leakages and their effect on the actual money multiplier. Governments can encourage this money creation process by injecting banks with new money. But how do governments go about doing this? Once we understand how the government, meaning the Fed, creates money, we can then go on in the next chapter to discuss the short- and long-run results of this monetary policy.

The institution charged with overseeing the money supply and creating money out of thin air is the Federal Reserve System. Let us turn to a brief survey of the Federal Reserve System. Here, we consider how it is organized, what purposes it serves, and what functions it has. The next chapter takes a closer look at the Fed in action.