The Money Multiplier and Bank Loans

This section presents an alternative way to understand the way that the money multiplier translates a
change in the monetary base into a change in the money supply.
An open market purchase increases transfers money from the Fed to individuals, who either hold it as
cash or deposit it in a financial institution. If it is deposited in a financial institution, the reserves of that
institution immediately rise by the amount of the deposit. This increases the reserve ratio; the bank now
has more excess reserves. To reduce these excess reserves, it lends out more money. The person receiving
the loan either deposits it in the bank, or gives it to someone else who deposits some or all of it in the
bank. The money supply has now increased by more than the amount of the open market purchase. The banks
reserves increase by the amount of the deposit; again, its excess reserves rise and it must make more loans
to drive them back down. This process repeats and repeats until all banks are holding exactly the amount
of reserves they want to; the money supply increases again with every repetition. The banks reserves, of
course, increase to reflect the increase in the value of its deposits. The reserve ratio itself does not
necessarily change.
The money multiplier summarizes the total expansion of the money supply created by this process; it
describes the amount that a $1 increase in the monetary base increases the total money supply.