Money Multiplier

Money is a concept that is much easier to understand than to explain in the form of words. However, it can be described as an instrument or thing that is generally accepted as a mode of payment or as a Medium of Exchange in the economy, like a Rupee in India, a Dollar in the USA, or a Yen in Japan. The main motive behind the invention of Money was to eliminate the Barter System (the process of exchanging goods for acquiring goods) from the economy as it was becoming difficult to trade by exchanging goods.

“Anything that is accepted as a means of exchange (i.e., as a means of settling debts) and that at the same time, acts as a measure and as a store of value is called Money.”

– Prof. Geoffrey Crowther

Money Multiplier

Money Multiplier can be stated as the phenomenon in which the creation of money is done in the form of credit creations in the economy. In other words, a money multiplier can be described as the influence a central bank plays over the money supply by modifying the required reserve rates.

Money Multiplier or Deposit Multiplier measures the amount of money that the banks are able to create in the form of deposits with every unit of money it keeps as reserves. The Money Multiplier plays a great role in the banking system of the economy as every time the government needs to kick-start the economy, the multiplier helps decide what proportion of stimulation should be applied and in what manner.

Formula

The money multiplier is expressed as:

$Money~Multiplier=\frac{1}{r}~OR~\frac{1}{LRR}$
Where ‘r’ is the Reserve Ratio or the Cash Reserve Ratio, and it can be described as the minimum ratio required to be maintained by commercial banks.

Example 1

Calculate the money multiplier if the reserve ratio prevailing as per current conditions is 5%.

Solution

$Money~Multiplier=\frac{1}{r}~OR~\frac{1}{LRR}$

$=\frac{1}{0.05}$

= 20

Therefore, the value of Money Multiplier is 20.

Example 2

Calculate the total deposits created if initial deposits is of ₹2,000 crores and LRR is 11.5%.

Solution

Given: LRR is 11.5% or 0.115

$Money~Multiplier=\frac{1}{r}~OR~\frac{1}{LRR}$

$=\frac{1}{0.115}$

= 8.69

Initial Deposits= ₹2,000

Total Deposits=Initial Deposits x Money Multiplier

=2,000 x 8.69

= ₹17,380 crores.

Example 3

Calculate Money Multiplier from the given table.

Solution

According to the table, we have the following information:

LRR or Reserve Ratio = 20%

Total Primary Deposits, i.e., ₹5,000

Total Cash Reserve, i.e., ₹1,000

Total Credit Creation, i.e., ₹4,000

$Money~Multiplier=\frac{1}{r}~OR~\frac{1}{LRR}$

$=\frac{1}{20\%}$

$=\frac{1}{0.2}$

= 5
Therefore, the value of Money Multiplier is 5.

Example 4

Sayeba and Sukant were arguing on the concept of Money Multiplier. Sayeba says, “If we keep the reserve ratio low, then there will be more money supply and lower inflation in the economy.” However, Sukant says, “If we keep the reserve ratio high, there will be less money supply, which would reduce inflation in the economy.” Who is correct? Explain by taking the reserve ratio as 8% and 10%, respectively as an example.

Solution

Case 1(Sayeba):

Reserve ratio = 8%

$Money~Multiplier=\frac{1}{r}~OR~\frac{1}{LRR}$

$=\frac{1}{0.08}$

= 12.5

Money Multiplier = 12.5

Case 2(Sukant):

Reserve Ratio = 10%

$Money~Multiplier=\frac{1}{r}~OR~\frac{1}{LRR}$

$=\frac{1}{0.10}$

= 10

Money Multiplier = 10

The value of money multiplier states that by keeping a less reserve ratio, a country can infuse more money into the market. As more money flows into the market, it will increase inflation in the economy. Therefore, the statement made by Sukant is correct and with a higher reserve ratio, inflation in an economy will reduce.