Question about the money multiplier - Welker’s Wikinomics Page

The following question was submitted by “blobber008″ to the discussion forum at our class wiki:

When I need to find the maximum increase in the total money supply, where the money deposited is $100 and the reserve requirement is 10 percent, do I multiply the total money deposited by the money multiplier, or do I multiply the excess reserves by the multiplier to find the increase, or does it depend on the situation? I thought that I would multiply the initial deposit by the multiplier, thus getting an increase of $1000. My answer key, though, said that increase is $900. When I asked my teacher, she said that you subtract out the original $100 from the $1000 to get the increase in money supply.

The reason I’m confused is that another question asking for an increase resulting from the Fed buying securities from the public doesn’t subtract out the original value. Do you do something different when dealing with money in a bank/checking account and the purchase of securities? Or, do I really subtract out the initial deposit? If so, can you explain why?

This is a good question and one that often comes up among students and even teachers via the AP Economics teacher email group.

The basic difference between an individual depositing $100 and the Fed buying $100 worth of bonds from a commercial bank is that when the individual deposits money, it was already part of the money supply. This is is why the amount of new money created is only $900 when an individual deposits $100 in the bank. We multiply the $100 by the money multiplier (1/required reserve ratio), and then subtract the original deposit, since it was already held by the public, thus part of the money supply.

In the case of the Fed’s purchase of bonds, on the other hand, the $100 of new reserves at the bank are themselves new money, since money held by the fed is not part of the money supply. In this case, we multiply the change in deposits by the multiplier, and the new money created includes the initial change in deposits, which came from the Fed.

Thanks for your submission, hope that helped!

About the author: Jason Welker is a teacher at Zurich International School in Switzerland, where he teaches Advanced Placement and International Baccalaureate Economics. Jason was an international school student in Malaysia before studying economics at Seattle University then earning his Masters in Education. He calls Seattle and Northern Idaho home. In addition to maintaining an economics wiki and this blog for economics student and educators, Jason also gives presentations on using Web 2.0 tools in education at workshops and conferences around the world. His economics wiki won the 2007 "Best Educational Wiki" award from the "EduBlog Awards".

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