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Multiplier Effect

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The multiplier effect describes how an increase in some economic activity starts a chain reaction that generates more activity than the original increase. The multiplier effect demonstrates the impact that reserve requirements set by the Federal Reserve have on the U.S. money supply. Here's how the multiplier effect works: Suppose the Fed sets reserve requirement at 10%, so a bank can loan $90 of a $100 customer deposit. This $90 is deposited by a borrower in another bank, which loans out $81 (90% of $90). Through the multiplier effect of continuing deposits and loans, the amount of money in circulation increases. The multiplier effect is not completely uniform - eg, some money won't be deposited domestically -- but overall the multiplier effect is apparent. The multiplier effect gives the Fed an important tool for managing the money supply. If it raises reserve requirements from 10% to 15%, only $85 is lent, the multiplier effect diminishes, and money supply growth decelerates.

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