Economics

Holiday ~SAHAJ ARORA

Homework XII - C

MONEY
MULTIPLIER
 ✧ MONEY MULTIPLIER ✧

The monetary base has a multiplier effect on the money supply: the money multiplier is

1/f

If the Federal Reserve raises the monetary base by one dollar, then the money supply rises by 1/f dollars. For example, if the reserve
requirement is F = .10, then the money supply rises by ten dollars, and one says that the money multiplier is ten. The money-multiplier
process explains how an increase in the monetary base causes the money supply to increase by a multiplied amount. For example, suppose
that the Federal Reserve carries out an open-market operation, by creating $100 to buy $100 of Treasury securities from a bank. The
monetary base rises by $100.

STEP BY STEP EXPLANATION :

The money-multiplier process explains how an increase in the monetary base causes the money supply to increase by a multiplied amount.
For example, suppose that the Federal Reserve carries out an open-market operation, by creating $100 to buy $100 of Treasury securities
from a bank. The monetarybase rises by $100.
The seller receives the $90 and deposits it in his bank. The bank keeps . 10×$90 as
reserves, and loans the remaining $81 of excess reserves. The borrower uses the
money to buy something.

The seller receives the $81 and deposits it in his bank, and the
process continues, until the process cannot be continued anymore...

The total increase in the money supply is the sum of the increases at each step:

∆M = 100+ 90 + 81 + ···

MEANING..
..
Q.) What do you basically
mean by money multiplier ??
A.) The answer to the
question is :
In monetary economics, a money multiplier is one of
various closely related ratios of commercial bank
money to central bank money (also called the monetary
base) under a fractional-reserve banking system.[1] It
relates to the maximum amount of commercial bank
money that can be created, given a certain amount of
central bank money. In a fractional-reserve
banking system that has legal reserve requirements, the
total amount of loans that commercial banks are allowed
to extend (the commercial bank money that they can
legally create) is equal to a multiple of the amount of
reserves. This multiple is the reciprocal of the reserve
ratio minus one, and it is an economic multiplier.
 1. Money Multiplier = 1 / Reserve Ratio

Reserve Ratio = 25/100 = 1/4

Money Multiplier = 1 / (1/4) = 4

The money multiplier is thus 4.

2. Let's first compute the excess reserves (i.e. the funds that can be loaned out).

Excess Reserves =Bank Deposits - (Bank Deposits * Reserve Ratio)

APPLICATION = $300 Million - ($300 Million * 25%)

OF
=$225 Million

Increase in Money Supply = Additional money loaned out * Money Multiplier

MONEY = $225 Million * 4

= $900 Million

MULTIPLIER The answer is $900 Million.

3. Money Multiplier = 1 / Reserve Ratio

Reserve Ratio = 16/100 = 4/25

Money Multiplier = 1 / (9/50) = 6.25

The money multiplier is thus 6.25.

4. This will increase the amount of money in the country because a higher money multiplier leads to
more cash being generated for every single dollar of reserves.
GRAPHICAL REPRESENTATION OF
MONEY MULTIPLIER
We can see how banks create so much credit with
some initial deposits, they lend the money to
people and how the return of that money helps
them do so, such we’ll see in the next slide how
banks create a credit of ₹50,000 with an initial
deposit of just ₹10,000.
NUMERICAL EXPLANATION OF
MONEY MULTIPLIER
Suppose a man say X. Deposits Rs.10000 with a bank and the LRR is 20% which
means the bank can keep only the minimum Rs. 2000 as cash reserve. The Bank
can use the remaining amount of Rs. 8000 for giving loan to someone. The bank
lends to rupees 8000 to Y who is actually not given loan in cash, but only an
account is opened in his name and the amount is credited to his account.

Now Y is free to withdraw the amount to make payments. Since all the payments
are made through cheque, money spent by Y comes back to the bank in the form of
new deposits of ₹8000.

Again 20% of the new deposit (i.e Rs 1600) is kept the bank as cash reserve and
the balance ₹6400 is advanced to say, Z. Z is also not given loan in cash but the
Amount is credited to his bank, Z also makes payment through cheques so money
spent by Z comes back to bank in the form of new deposits of ₹6400. In this way
bank gets new demand deposit.

The process of this credit creation continues till derivative deposit becomes zero.
This multiple is called the MONEY MULTIPLIER.