Let's review how the banking system creates more money in circulation. Money in circulation is the money that people use to purchase goods and services. We will review how an injection of cash into the banking system generates an increase in overall money supply.
Let’s assume that the Federal Reserve Bank injects $1,000 in cash into the banking system. The banks that form the banking system have a choice. Should the bank lend the money or put that money in reserve? Let's assume that there is a required reserve rate of 10%. That means for every dollar the bank has on deposit from its customers, the bank must put 10% on reserve. We are also going to assume that the remaining 90% of that dollar is loaned out in the form of new money and that all banks have the same reserve requirement and all the banks act in the same manner.
So the Central Bank injects $1,000 of new money into the banking system. The first bank takes 10% and puts it on reserve and loans out the remaining $900 to a coffee shop. The coffee shop needs to buy roasted coffee beans and so it buys $900 of beans from the coffee roaster. The coffee roaster deposits that $900 into her bank. The coffee roaster's bank puts 10% of that $900 on reserve and loans out the remaining $810 to a shoe retailer.
The shoe retailer needs new inventory, so the retailer goes to the shoes wholesaler and buys $810 of shoes. The shoe wholesaler
deposits the $810 in her bank. This series of events continues. When finally completed, this theoretical series of events generates $10,000 of money, beginning with the original $1,000 cash injection and using the 10% reserve requirement throughout..
This process demonstrates a simple money multiplier. A simple money multiplier equals one divided by the reserve requirement. In our example, the reserve requirement was 10%. One divided by .10 equals ten. The simple money multiplier, for our example, is ten. $1,000 of new money injected into the banking system grew to $10,000.
This example assumes there are no reserve leakages in the process -- the bank lends the full 90% and does not maintain excess reserves. The example also assumes that every loan leads to an equal amount being deposited in another bank.
In the real world, the money multiplier is quite a bit different. In the month prior to the financial crisis of 2008, the U.S. money multiplier was approximately 1.5. For every dollar injected into the economy by the Central Bank, about a half dollar more was created by the banking system.
In the post-crisis period in 2011, the money multiplier became a "money divider" and was actually point seven. So the banking system actually decreased the money injected by the Central Bank into the banking system. This happened because most banks increased their excess reserves holdings to reduce their financial leverage and risk. Banks became more conservative in their lending after this financial crisis.
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