What is Money Multiplier?

4 minute read
Money Multiplier

Have you ever wondered what happens to the money which you deposit in banks? Does the money simply remain there? Have you ever heard about the economic term called money multiplier? No? Don’t worry as in this blog, we may cover all important points on the money multiplier topic. So stay tuned and read this blog till the end. 

Understanding the Concept of Money Multiplier

The money multiplier is a phenomenon of creating money in the economy in the form of credit creation. The money is created in the market based on the fractional reserve banking system. It is also sometimes called monetary multiplier or credit multiplier. This topic is also taught in class 12 Economics!

It is the maximum limit to which money supply can be affected by bringing changes in the number of money deposits deposited by the people in the market. The effect of the money multiplier can be seen in commercial banks of the economy. Commercial banks accept money or deposits. They keep some amount as a reserve with them and lend other shares as loans to the people. 

The amount of money that is kept as reserves by these commercial banks for the withdrawal purposes of the depositors at any time is known as the reserve ratio or the required reserve ratio or cash reserve ratio.

Formula of Money Multiplier

Mathematically, the concept of money multiplier can be represented with the help of a formula which is a follows:

Money Multiplier = 1/LRR  or  1/r

Where LRR is the legal reserve ratio. It is the minimum ratio of deposits that is legally required to be kept by the commercial banks of the economy with themselves and with the central bank of India, also known as the RBI.

Also Read: Economics Project Class 12

Example of Money Multiplier (Hypothetical)

Deposit Creation by Commercial Banks 

Deposits (Rs) Loans (Rs)  Cash Reserves (Rs)(LRR= 0.2) 
Initial Round  100 90 10
Round 1 90 81 9
Round 2  81 72.9 8.1
Round 3 72.9 65.7 7.2
Round 4  65.7 59.2 6.5
Round 5 59.2 53.3 5.9
Total  1000 900 100

The following rounds after Round 5 will be continued in the same manner till the time total deposits become Rs 1,000, total loans lent become Rs 900 and total cash reserves become Rs 100. 

It can also be explained with the help of the following formula:
Money Multiplier = 1/LRR = 1/0.1 = 10
Hence, the total money creation is-
Money creation= Initial Deposit * 1/LRR = 1000 * 10 = 1,000

Note: the lower the LRR, the higher will the money multiplier effect and more will be the money creation. For example, if the LRR = 5% = 0.05, the money multiplier would be 20 (1/0.05 = 20). On the contrary, if the LRR= 20% = 0.2, the money multiplier would be 5 (1/0.2). 

What is the Multiplier Effect?

A popular term in economics, the m multiplier effect defines the process of proportional increase or decrease in final income that results from an injection, or withdrawal, of capital. The Multiplier Effect significantly assists in measuring the impact of changes in various economic activities such as investment or spending and what it will have on the total economic output.

Multiplier = Change in Income/Change in Spending

Money Supply Multiplier Effect

The multiplier effect is mostly taken from a banking and money supply perspective by economists and bankers. This process is called the money supplier multiplier effect. In general, there are multiple levels of money supply across countries that can be commonly determined as:

  • The first level, dubbed M1, refers to all of the physical currency in circulation within an economy.
  • The next level, called M2, adds the balances of short-term deposit accounts for a summation.

When a customer makes a deposit into a short-term deposit account, the banking institution can lend one minus the reserve requirement to someone else. The size of the multiplier depends on the percentage of deposits that banks are required to hold as reserves. While the original depositor maintains ownership of their initial deposit, the funds created through lending are generated based on those funds. If a second borrower subsequently deposits funds received from the lending institution, this raises the value of the money supply even though no additional physical currency actually exists to support the new amount.

What is a Multiplier?

In economical terms, the economic factor that causes changes in many other related economic variables is broadly referred to as the Multiplier. The term is usually used in reference to the relationship between government spending and total national income. In terms of gross domestic product, the multiplier effect causes changes in total output to be greater than the change in spending that caused it.

So there are 2 types of Legal Reserve Ratios that are being taught in class 12 macroeconomics. They are:

  1. Cash Reserve Ratio (CRR): It is a type of ratio which refers to the minimum percentage of a commercial bank’s total deposits which they are required to keep with the central bank or the RBI. 
  2. Statutory Liquidity Ratio (SLR): It refers to the minimum percentage of the net total demand and time liabilities which are required to be maintained by the commercial banks. Basically, it is the minimum reserve of the total deposit which is required to be kept by the commercial banks with themselves. 
Credits – Marginal Revolution University

Must Read: Difference Between Macro and Micro Economics

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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