MONEY MULTIPLIER

Economy and Finance

MONEY MULTIPLIER

19 Feb 2024 Zinkpot 138

Money Multiplier is a concept used in economics and banking to describe the ratio by which a change in the monetary base (such as currency and reserves) results in a larger change in the money supply of a country.
It helps illustrate how an initial injection of money into the banking system can lead to a more significant increase in the overall supply of money.
Mechanism:
- Initial Deposit: Imagine you deposit Rs. 1000 into a bank. This initial deposit is the starting point.
- Reserve Requirement: Banks are required to keep a fraction of deposits as reserves, which they cannot lend out. Let's say the reserve requirement is 10%.
- Lending by Banks: With a 10% reserve requirement, the bank can lend out Rs. 900 (90% of the Rs 1000 deposit) to someone who needs a loan.
- New Deposit: The person who borrowed Rs 900 now deposits it into another bank. This Rs 900 becomes a new deposit in the second bank.
- Repeat the Process: The second bank must also keep 10% (Rs 90) as reserves but can lend out the remaining Rs 810. This Rs 810 is then borrowed and deposited in another bank, and the process continues.
- Multiplying Effect: As this process repeats, more money is created with each new deposit and loan. The cycle continues until the total increase in the money supply is much larger than the initial deposit.
The formula for Money Multiplier: The formula for the money multiplier is the reciprocal of the reserve requirement. If the reserve requirement is 10%, the money multiplier is 1/0.1, which equals 10:
- Money Multiplier = 1 / Reserve Requirement
In simple terms, the money multiplier shows how much the money supply can expand through the banking system as a result of fractional reserve banking. It's important to note that the actual multiplier can vary based on factors like the reserve requirement and the willingness of banks to lend.
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