📚 Topic Summary
The money multiplier is a crucial concept in macroeconomics that explains how an initial change in the money supply, usually from a new deposit, can lead to a larger overall change in the total money supply within an economy. It's essentially the ratio of the change in the money supply to the initial change in reserves. This process hinges on fractional reserve banking, where banks are only required to hold a fraction of their deposits as reserves and can lend out the rest.
The key determinant of the money multiplier's potential is the reserve ratio, which is the percentage of deposits that banks must hold and cannot lend out. The simple money multiplier is calculated as $1 / \text{Reserve Ratio}$. This formula assumes that banks lend out all excess reserves and that all loaned money is redeposited into the banking system, leading to a continuous cycle of lending and deposit creation that expands the money supply far beyond the initial deposit.
📝 Part A: Vocabulary
Match each term (1-5) with its correct definition (A-E).
- 1️⃣ Money Multiplier
- 2️⃣ Reserve Ratio
- 3️⃣ Required Reserves
- 4️⃣ Excess Reserves
- 5️⃣ Demand Deposits
Definitions:
- 📈 A. The portion of reserves that a bank holds over and above the required amount.
- 🔄 B. A measure of how much the money supply expands with each dollar increase in bank reserves.
- 💳 C. Funds held in bank accounts that can be withdrawn at any time without prior notice.
- ⚖️ D. The fraction of deposits that banks are required to hold in reserve.
- 🔒 E. Funds that banks must hold in reserve, not available for lending.
✍️ Part B: Fill in the Blanks
Complete the following paragraph with the correct terms.
When banks receive new deposits, they must hold a portion as _____(1)_____. Any funds held above this minimum are called _____(2)_____. Banks can _____(3)_____ these excess funds, which then get redeposited elsewhere, expanding the money supply. This expansion is quantified by the _____(4)_____, calculated as $1 / \text{_____(5)_____}$.
🤔 Part C: Critical Thinking
The simple money multiplier assumes that banks lend out all their excess reserves and that all funds loaned are redeposited into the banking system. In reality, what two factors might cause the actual money multiplier to be smaller than the simple money multiplier, and why?