After the 2008 financial crisis, the Federal Reserve dramatically expanded the monetary base through large-scale bond purchases. Yet the broad money supply grew far less than the simple money multiplier formula predicted. What best explains this?
AThe Fed's bond purchases were too small to have a meaningful effect on reserves
BBanks held large quantities of excess reserves rather than lending them out, collapsing the effective multiplier
CHouseholds withdrew cash en masse, reducing the monetary base
DThe required reserve ratio was raised, limiting money creation
The money multiplier formula (1/r) assumes banks lend out every dollar above the reserve minimum. After 2008, the Fed began paying interest on excess reserves, making it attractive for banks to park funds at the Fed rather than lend. Banks held enormous excess reserves, so new base money was not multiplied into broad money. This is exactly why the monetary base and the money supply are related but not the same — the multiplier depends on bank behavior, not just central bank policy.
Question 2 Multiple Choice
A bank receives a new $1,000 deposit. The required reserve ratio is 10%. According to the money multiplier model, what is the theoretical maximum total increase in the money supply (including the original deposit)?
A$900 — the amount the bank can lend out
B$1,000 — only the original deposit counts
C$9,000 — just the new loans created beyond the original deposit
D$10,000 — the original deposit times 1 divided by the reserve ratio
The money multiplier is 1/r = 1/0.10 = 10. Starting from the $1,000 deposit, the total potential increase in the money supply is $1,000 × 10 = $10,000. The $900 option (answer A) is just the first round of lending — it misses the subsequent rounds of re-deposit and re-lending that make up the full multiplier effect. The key insight is that each loan becomes someone else's deposit, which is then partially re-lent, in a chain that sums to the full multiplier formula.
Question 3 True / False
When a commercial bank makes a loan, it transfers money out of its existing deposits to the borrower.
TTrue
FFalse
Answer: False
This is the most important misconception about money creation. Banks do not lend out existing deposits — they create new deposits. When Bank A lends $900, it credits $900 to the borrower's deposit account, creating that money from scratch. The borrower now has $900, and existing depositors still have their $1,000. Total deposits in the system have grown. Lending precedes and creates deposits in modern banking, not the reverse. This is why banks can collectively create far more money than the base currency in existence.
Question 4 True / False
The money multiplier gives a theoretical maximum for money creation that is rarely achieved in practice, because banks hold excess reserves and households hold cash outside the banking system.
TTrue
FFalse
Answer: True
The simple formula 1/r assumes every dollar above the reserve minimum is immediately lent out and re-deposited — a complete chain with no leakage. In practice, two leakages shrink the real-world multiplier: banks hold excess reserves (above the required minimum) for safety or profitability reasons, and households hold some money as cash rather than bank deposits. Cash held outside banks cannot be re-lent, breaking the deposit chain. Both leakages mean the actual multiplier is always smaller than the theoretical maximum.
Question 5 Short Answer
Why can't a central bank directly control the broad money supply simply by expanding the monetary base?
Think about your answer, then reveal below.
Model answer: Because broad money creation depends on the banking system's lending decisions, not just on the monetary base. The central bank controls the base (currency + reserves), but whether those reserves get multiplied into loans and deposits depends on banks' willingness to lend and households' preferences for cash versus deposits. If banks hold excess reserves instead of lending, the multiplier collapses and base expansion does not translate into proportional money supply growth.
This is the key distinction between the monetary base (what the central bank controls directly) and broad money (M1, M2, which includes bank deposits). The money multiplier links them, but it is not a fixed mechanical ratio — it reflects the behavior of millions of private actors. After 2008, quantitative easing expanded the base dramatically but money supply growth was modest because banks sat on excess reserves. Central banks influence, but do not directly determine, how much money the banking system creates.