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Last week, Aarav gave his dad ₹500 to put in the bank. A few days later, he asked, “Is my money just sitting there doing nothing?” His dad smiled and said, “Actually, the bank uses your money to help others and somehow, it creates more money too.”
That got Aarav curious. How can banks turn ₹500 into more money without printing anything new?
The answer is something called the money multiplier. It’s a simple idea from economics that explains how banks help grow the total money in the economy. In this blog, we’ll break it down with examples and easy steps.
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What Is the Concept of Money Multiplier?
Money multiplier is just a way to explain how banks can make more money using the money people put in. When you give your money to the bank, they don’t keep all of it. They keep a small part safe and lend the rest to someone else. That person might spend it or put it in another bank and the same thing happens again.
So, from your one deposit, more money gets added to the system. That’s called the money multiplier.
The rule is simple:
Money Multiplier = 1 ÷ LRR (Legal Reserve Ratio)
The smaller the LRR, the more money the banks can create.
Formula of Money Multiplier
The formula for money multiplier is super simple. It goes like this:
Money Multiplier = 1 ÷ LRR
LRR stands for Legal Reserve Ratio, which is just the small part of your money the bank has to keep safe and not lend out.
So, if the LRR is 0.2 (or 20%), the formula will be:
Money Multiplier = 1 ÷ 0.2 = 5
That means ₹100 can turn into ₹500 in the economy.
The smaller the LRR, the bigger the multiplier. That’s because banks get to lend more, and that keeps the money cycle going. If the LRR is higher, banks lend less, and the multiplier becomes smaller.
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Example of Money Multiplier
Let’s say you deposit ₹100 in the bank, and the LRR (Legal Reserve Ratio) is 10% or 0.1. That means the bank keeps ₹10 and lends out ₹90.
Now see what happens step by step:
| Round | Deposits (₹) | Cash Reserve (10%) | Loan Given (₹) |
| You | 100 | 10 | 90 |
| Round 1 | 90 | 9 | 81 |
| Round 2 | 81 | 8.1 | 72.9 |
| Round 3 | 72.9 | 7.29 | 65.61 |
| Round 4 | 65.61 | 6.56 | 59.05 |
| Round 5 | 59.05 | 5.91 | 53.14 |
| … | … | … | … |
| Total | ₹1000 | ₹100 | ₹900 |
So, your ₹100 turns into ₹1000 in total deposits. That’s how the money multiplier works—it keeps going until no more can be lent.
What Is the Multiplier Effect?
In economics, the multiplier effect explains how a change in spending (like investment or government money) can lead to a bigger change in total income.
Think of it as a money chain reaction. When someone spends money, for example, a business invests in new chairs so it doesn’t just stop there. The carpenter earns money, then spends it on groceries, and the grocery shop pays its workers. One small spend? It sets off a cycle that boosts everyone’s income.
Formula:
Multiplier = Change in Income ÷ Change in Spending
Money Supply Multiplier Effect
This idea also shows up in banking. It’s called the money supply multiplier. When you deposit money in a bank, they don’t just keep it sitting there. A part of it is kept safe (called the reserve), and the rest is lent to someone else. That person spends it, it gets re-deposited, and the cycle continues.
Banks follow levels like:
- M1: All the cash and coins actually moving around.
- M2: That plus short-term deposits, like savings accounts.
The smaller the reserve requirement, the bigger the multiplier. That’s how banks literally help “grow” money.
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Types of Legal Reserve Ratios
Banks can’t lend out all the money people deposit. They have to keep a part of it aside. These are called legal reserve ratios. There are two main types you should know:
1. CRR – Cash Reserve Ratio
This is the percentage of money that banks must keep with the RBI (India’s central bank). They can’t touch this money or use it for lending.
Example:
If the CRR is 4% and someone deposits ₹1000, the bank must keep ₹40 with the RBI and can use the rest to give loans.
2. SLR – Statutory Liquidity Ratio
This is the percentage of money that banks must keep with themselves, but in the form of cash, gold, or government bonds.
Example:
If SLR is 18%, then from ₹1000, the bank has to keep ₹180 in liquid form (like cash or bonds) before lending out anything.
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FAQs
Answer: Money multiplier is how banks create more money from the money people deposit. It tells us how much total money can be created from a single deposit, by giving loans again and again.
Answer: The formula is:
Money Multiplier = 1 ÷ LRR
Where LRR means the Legal Reserve Ratio — the part banks must keep safe and not lend.
Answer: No. It’s always more than 1 because banks lend money and that adds to the total money supply. If it were less than 1, banks wouldn’t be creating more money at all.
Answer: Mainly, the reserve ratio (LRR). Lower LRR = higher multiplier. Higher LRR = lower multiplier. Other things like how much cash people keep at home or if banks are lending actively also affect it.
Answer: Multiplier in economics is about how spending affects income (like in fiscal policy). Money multiplier is only about how banks increase the money supply through deposits and loans.
Relatable Reads
Hope you understood the concept of Money Multiplier with this blog! Did we miss anything? Let us know in the comment section below! For more such amazing reads and amazing study/revision notes, stay tuned with Leverage Edu.
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