Multiplier Effect

The multiplier effect refers to the increase in the money supply due to banks making loans. This is due to the fractional reserve banking system where money is literally created as a bank makes loans. The restriction on how much money the banks can create by lending out is determined by the reserve requirement ratio.

For example, if the reserve requirement ratio is 10%, then banks must hold $10 in reserve for every $100 in deposits.  Assume a customer deposits $100 into a bank, $90 can  be lent out, $10 must be held in reserve. The $90 can be deposited at another bank which will keep $9 in reserve and lend out $81. The process can go on until $900 in new deposits is created.

This implies that for the multiplier effect to work, the monetary base must increase assuming the reserve requirement ratio stays unchanged. During recessions and depressions, the multiplier effect may not come into action as banks are fearful to lend.