Cambridge International as and a level Economics Ebook

The credit multiplier
By estimating what liquidity ratio to keep, a bank will 
be able to calculate its credit multiplier. Th
is is also 
referred to as a bank or credit creation multiplier, 
and shows by how much additional liquid assets will 
enable banks to increase their liabilities. It is given by 
the formula:
V lue of new assets created
Value of change in liquid asset
a
ss
For example, if total deposits rise by $600 million as a result 
of a new cash deposit of $100 million, the credit multiplier is 
$600m/$100m 
=
6. It is also possible to calculate the 
credit 
multiplier
, in advance, by using the formula:
100
liquidity ratio
Credit multiplier: 
the process by which banks can make 
more loans than deposits available.
KEY TERM
Liquidity ratio
If a bank keeps a 
liquidity ratio
of 5%, the credit multiplier 
will be 100/5 
=
20. Knowing this enables a bank to calculate 
how much it can lend. It fi rst works out the possible 
increase in its total liabilities. Th
is is found by multiplying 
the change in liquid assets by the credit multiplier. So, if the 
credit multiplier is 20 and liquid assets rise by $40 million, 
total deposits can rise by $40 million
× 
2 
=
$800 million.
To work out the change in loans (advances), the change 
in liquid assets is deducted from the change in liabilities. 
Th
is is because the change in liabilities will include 
deposits given to those putting in the liquid assets. In 
the example, the change in loans can be $800 million
− 
$40 million 
=
$760 million.
In practice, however, a bank may not lend as much as 
the credit multiplier implies it can. Th
is is because there 
may be a lack of households and fi rms wanting to borrow 
or a lack of credit-worthy borrowers. If banks persist in 
lending to borrowers with poor credit ratings, as was the 
case in the US sub-prime market, the risk of default is high 
and can have serious consequences on a bank’s liquidity.
A bank is likely to change its liquidity ratio if people 
alter the proportion of their deposits they require in cash, 
if other banks alter their lending policies or if the country’s 
central bank requires banks to keep a set liquidity ratio.
A central bank may seek to infl uence commercial 
banks’ ability to lend. For example, it may engage in open 
market operations. Th
ese involve the central bank buying 
or selling