How does a stimulus program (through the money multiplier) affect the money supply?
A stimulus program can impact the money supply through the money multiplier effect. To understand this process, we need to break it down into a few steps:
1. Initial Injection: The stimulus program involves the government injecting a certain amount of money into the economy. For example, let's say the government injects $100 million.
2. Bank Reserves: Banks are required to hold a portion of their deposits as reserves, which they cannot lend out. Let's assume banks have a reserve requirement of 10%. So, out of the $100 million injection, banks must keep $10 million as reserves and cannot loan it out.
3. Excess Reserves and Lending: The remaining $90 million can be lent out by banks to borrowers, such as individuals or businesses. Let's assume all of this money is loaned out.
4. Deposits and Fractional Reserve Banking: When banks make loans, the borrowers receive the loan amount in their bank accounts. These new deposits can be seen as an expansion of the money supply. This is because of the fractional reserve banking system, where banks only need to keep a fraction of the deposits as reserves. Assuming a reserve requirement of 10%, banks keep 10% of the new deposits as reserves ($9 million) and loan out the remaining 90% ($81 million).
5. Repeated Process: The borrowers who received the loans can then use the money for spending, investing, or depositing it into their own bank accounts. If deposited, these funds become new deposits in the banking system. Again, banks keep 10% as reserves and loan out the remaining 90%. This process continues iteratively, with each round resulting in a smaller loan amount but still expanding the money supply.
6. Money Multiplier Effect: The process of banks repeatedly lending out a fraction of the deposits continues until the total expansion of the money supply is complete. The money multiplier effect quantifies this expansion by dividing the initial injection by the reserve requirement. In our example, with a reserve requirement of 10%, the money multiplier is 1/0.1 = 10. Therefore, the initial $100 million injection ultimately results in a $1 billion expansion of the money supply.
In summary, a stimulus program injects money into the economy, which banks can then lend out. Through the fractional reserve banking system and the money multiplier effect, this initial injection has the potential to significantly expand the money supply.