What is Money Multiplier?

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

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 amount of money deposits deposited by the people in the market. The effect of money multiplier can be seen in commercial banks of the economy. The 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 the Round 5 will be continued in the same manner till the time total deposits become Rs 1,000, total loans lended 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). 

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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