Infernal Ramblings
A Malaysian Perspective on Politics, Society and Economics

Multiplying Money

Written by johnleemk on 2:52:10 pm Jun 1, 2007.

One of the most curious and interesting processes in banking is how money multiplies. They say that money begets more money, and it has actually been mathematically proven.

One of the most elementary concepts any student of economics learns about the banking system is how the money multiplier works. To first understand what the money multiplier is, you need to know how saving and loaning money works.

When you save your money in a bank, the bank does not obtain the money to pay you interest out of nowhere. Most of us do not realise it, but our bank is basically a middleman — it allows us to loan our money to entrepreneurs who need capital.

In other words, our savings become loans. Now, when the bank loans this money to someone else, they do not stuff it under their mattress. No — they save it in a bank, which can in turn loan this money to someone else. Do you see where this is going?

What this basically means is that the banks can effectively turn one dollar into an unlimited amount of money — money truly begets more money!

Still, you might be scratching your head at this point — if this is the case, why is it that you can withdraw your money from the bank at any time? If your money has been loaned to someone else, how do you get it back?

The banks are of course not idiots. They always keep a certain amount of cash in reserve for those who want to take out some or all of their savings. The banks are betting that they will not suffer from a "bank run", where most of their customers decide to withdraw their money.

How much the banks keep in reserve thus determines how much the money will multiply. Virtually all central banks require commercial banks to hold a certain cash reserve ratio — for the purposes of this example, let's say the cash reserve ratio is 10%.

The formula for multiplying money is thus simply 1 divided by the cash reserve ratio (0.1 in our example). So, one dollar can theoretically become ten dollars in an economy where the minimum cash reserve ratio is 10%.

At this point, you might be thinking that this is fundamentally unfair — why should the banks be loaning out your money, and risking a bank run? Doesn't it make the economy unstable? And what about the consequent inflation of the money supply when one dollar can become ten dollars?

The interest rates you earn on your savings are basically proportional to the risk your bank is assuming. If your bank makes many risky loans or investments, they will reward you with a higher interest rate; if they play it safe, they will pay you a pittance in interest.

The reason for this is simple — the banks profit off your savings. When they invest in a new enterprise, if the enterprise takes off, they get a portion of the profits. That is why they are willing to risk a bank run — because if they play it right, they can reap bountiful rewards.

And, of course, some of these rewards go to you in the form of interest. The monetary system operates just like the ideal free market of goods and services — someone provides raw materials (money), someone sells those raw materials (the bank loans the money), someone creates value out of those materials (the entrepreneur starts a business), and the created wealth gets passed around to everyone along the supply chain.

If you dislike it, you are of course free to opt out of this market system. But stuffing money under your mattress is worse than saving — interest rates on savings accounts may not keep pace with inflation, but a measly 3% per annum is better than nothing.

Which brings us to another peripheral question — doesn't the existence of the money multiplier create inflation? Well, yes, it probably does, since it results in an expansion of the money supply.

But what would you rather have? Banks that can't invest any money, can't take any risks? Banks which don't give you interest on your savings? Are you willing to take the burden of investing your money for yourself? Probably not — we don't do more than dabble in the stock market because we know we aren't that smart.

Moreover, since the monetary authority controls the money supply anyway, all it has to do is adjust its calculations to account for the money multiplier. If it wants an inflation rate of such and such, it just accounts for the fact that its actions will have a tenfold impact on the economy and adjusts its plans accordingly.

(The question of avoiding inflation is another thing altogether, and is one that will have to be addressed at some other time. For now suffice it to say that achieving a 0% inflation rate is probably impossible, and highly undesirable.)

Knowing how the money multiplier and the banking system works is quite enlightening. Most people don't realise that their bank is actually acting as their agent, investing their money for them. Saving your money is actually just another form of investment — albeit a low-risk and low-return form of it.

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Infernal Ramblings is a Malaysian website focusing on current events and sociopolitical issues. Its articles run the gamut from economics to society to education.

Infernal Ramblings is run by John Lee. For more, see the About section. If you have any questions or comments, do drop him a line.

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