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Understanding Money Multiplier
A money multiplier is a method of demonstrating the maximum amount of broad money that commercial banks could create for a given fixed amount of base money and reserve ratio. The understanding of the money multiplier is very important to understand money supply and money creation in the economy.
- Money multiplier (m) is the inverse of the reserve requirement (R)
- For example, with a reserve ratio of 25%, this reserve ratio can also be expressed as a fraction: R = 1/4
- As a result, the money multiplier, m, will be calculated as:
- This figure is multiplied by the number of reserves to calculate the money supply's maximum potential amount.
- For example, if the Reserve Ratio is 1/10 (10 percent) or the Money Multiplier is 10, Rs.100 can be multiplied by 10 to generate Rs.1000 in money supply.
- When the Reserve Ratio is 1/4 (25%) or the Money Multiplier is 4, the money supply is only Rs. 400.
- The money multiplier effect can be seen in the banking system of a country. An increase in bank lending should result in an increase in a country's money supply.
- The multiplier's size is determined by the percentage of deposits that banks are required to hold as reserves.
- When the reserve requirement falls, so does the money supply reserve multiplier, and vice versa.
- The money multiplier is a key component of the fractional banking system.
- There is an initial increase in bank deposits (monetary base).
- The bank holds a portion of this deposit in reserves and lends the remainder.
- This bank loan will then be re-deposited in banks, allowing for further increases in bank lending and the money supply.
- Spending on imports - When consumers purchase imports, money leaves the economy.
- Taxes will be deducted as a percentage of your income.
- Not all money is spent and circulated; a sizable portion is saved.
- Currency Drainage Ratio - This is the percentage of banknotes held in cash by individual consumers rather than deposited in banks.
- If consumers deposited all of their cash in banks, the money multiplier would be greater.
- However, if people keep their funds in cash, banks will be unable to lend more.
- Bad loans -A bank may lend Rs.100, but if the company fails, the money is never deposited in the banking system.
- Safety reserve ratio -This is the percentage of deposits that a bank may wish to keep in excess of the statutory reserve ratio.
- For example, the required reserve ratio maybe 5%, but banks may prefer to keep 5.25%.
- More money may not be available for lending. Even if banks could lend 95 percent of their deposits, this does not mean they would. People may not want to borrow during a recession, but they prefer to save.
- Banks may be unwilling to lend. Furthermore, banks may refuse to lend at various times, for example, during a recession when they believe firms and individuals are more likely to default. As a result, banks have a higher reserve ratio.
POSTED ON 17-08-2021 BY ADMIN
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