How does the money multiplier work?

The money multiplier is a concept from traditional monetary economics describing how a given amount of central bank reserves (the monetary base) gets amplified into a larger amount of broad money (M2) through the fractional reserve banking system. In the textbook model, if the reserve requirement is 10%, a bank receiving $100 in deposits can lend out $90, which gets deposited elsewhere, enabling another $81 in lending, and so on, theoretically multiplying the initial deposit tenfold.

The formula is straightforward: the theoretical multiplier equals 1 divided by the reserve requirement ratio. With a 10% reserve requirement, the multiplier is 10x, meaning $1 billion in new reserves could theoretically support $10 billion in deposits. This model underpinned the traditional view of monetary policy transmission: the central bank adjusts reserves, banks mechanically expand or contract lending, and the money supply responds proportionally.

In practice, the textbook multiplier has been effectively defunct since 2008. When the Federal Reserve flooded the banking system with reserves through quantitative easing (reserves rose from about $10 billion in 2007 to over $3 trillion), the money supply did not multiply proportionally. Banks sat on excess reserves rather than lending them out, either because loan demand was insufficient, capital requirements constrained lending, or banks preferred earning interest on reserves (IOER) over making risky loans. The reserve requirement was reduced to zero in March 2020, officially ending the mechanical link between reserves and lending.

Modern monetary economists generally view money creation as demand-driven rather than supply-driven: banks create money by making loans when creditworthy borrowers want to borrow, and then seek reserves afterward to meet settlement needs. The central bank accommodates reserve demand at its target rate. This "endogenous money" view explains why massive reserve creation through QE did not produce proportional broad money expansion or runaway inflation. For market participants, this means focusing on credit demand and lending conditions (observable in bank loan surveys and credit growth data) rather than the monetary base when assessing monetary policy transmission.