Money Multiplier Third Add-In Section

Let's look at an economy where banks are required to hold 20% of their deposits in the form of reserves, the public holds no currency, and banks hold no excess reserves. Into this economy $1,000 in bank reserves appears (perhaps the central bank bought bonds from the public). These reserves are put into Bank 1. Bank 1 keeps $200 on hand and loans out $800. Immediately the money supply has increased by $1,000. When the $800 in loans are spent they become deposits into Bank 2. Bank 2 takes those deposits and keeps $640 while loaning out $160. The process continues.

In the table below we show the movement of the money through 3 rounds of the banking system. Then we show the totals after 50 rounds through the banking system. It doesn't matter if all of this transpires in one bank or many banks, so long as the loans are made and deposits are spent.

The change in the money supply will be proportional to the change in the monetary base. Here that proportion is given by (1/reserve requirement) = 1/0.2 equals 5. The change in the monetary base is $1,000 and the resultant change in the money supply will be $5,000.