What is the Multiplier Effect?

The multiplier effect is a phenomenon used to describe an expansion in the money supply within a specific nation. With this effect, the ability of banking institutions to make loans to individuals and businesses increases. Seen as a logical sequence of events that can be used to redirect the economy of a nation, this same general concept may also be used in helping to make adjustments in the economic stability of a given region within a nation, simply by making adjustments in the available money supply.

While helpful in allowing an economy to respond to current economic conditions, the decision to increase the money supply is not an arbitrary one that is made without allowing for any legal standards or regulations that may apply to the process. Many nations rely on what is known as a reserve ratio in order to determine the amount of expansion that will take place as part of the multiplier effect. This simply means maintaining a balance between the amount of money each bank must hold in reserve in comparison to the amount of deposits that are made to that bank. As more deposits are made, the bank is able to provide customers with greater loan opportunities, which in turn helps to stimulate the economy.

Determining the amount of that reserve requirement is key to determining the outcome of the multiplier effect. When deemed prudent, governments may choose to use their reserve or national bank systems to increase the requirement. This simply means that a larger percentage of the deposits must be kept in reserve rather than used in granting loans. This method can be used to help slow an economy that shows indications of accelerating out of control. By the same token, lowering the requirement has the multiplier effect of helping to stimulate a sluggish economy by placing more money back into the marketplace and encouraging the purchase of goods and services.

When used prudently, the multiplier effect can enhance the current status of an economy, allowing it to achieve the desired balance between extremes of recession and inflation. Should a government misinterpret the economic indicators and make adjustments to the reserve requirement that produce results other than those desired, the resulting multiplier effect may be economic circumstances that leave consumers in worse financial condition than before. For this reason, the task of adjusting the reserve requirement requires intense scrutiny of what is happening within the economy, projecting what type of impact shifting the requirement will have on different sectors of the economy, then determining what other processes must take place at the same time as the adjustment in order to produce the most beneficial effect for all concerned.