Money is created when a bank receives a deposit, sets some of the funds aside for reserves, and loans out the rest. Deposits have at this point increased by the amount of the original deposit and the amount of the loan.
The size of this money multiplier depends on the required reserve ratio, the part held back by the banks, much as the expenditure multiplier depends on the marginal propensity to save, the part of income held back rather than consumed.
Simple Money Multiplier= 1/Required reserve ratio
Simple Money multiplier= 1/5%
Simple Money Multiplier= 100/5
Simple Money Multiplier= 20
But this is really an oversimplified view because it assumes that everyone deposits all of their money into the bank and that the banks loan out all they are legally allowed. Neither assumption is accurate. Individuals and firms hold cash, banks hold reserves in excess of the requirement, and some funds leave the country and are held by foreigners. These are referred to as leakages; a more accurate money multiplier would account for these leakages as well as required reserves.
Leakage adjusted money multiplier= 1/Required reserves+leakages%
Leakage adjusted money multiplier= 1/40%
Leakage adjusted money multiplier= 100/40
Leakage adjusted money multiplier= 2.5
With leakages, less is loaned out throughout the multiplier process, and the resulting money multiplier is smaller. During financial crises, banks are more hesitant to make loans, and so excess reserves will increase. The money multiplier therefore decreases.
This is because during financial crisis the banks aren't willing to engage into transactions more,they aren't willing to lend and accept deposits due to more such possibilities of default as a result the monetary base falls and reserve requirements rises (to restrict money supply).
Cash held by the Federal Reserve is not a leakage because this cash is not even part of the official money supply. It becomes money only when it leaves the Fed and circulates among firms, banks, and individuals.
