Model Answer
0 min readIntroduction
The money multiplier is a fundamental concept in monetary economics, explaining how an initial deposit can lead to a larger increase in the overall money supply. In a fractional reserve banking system, banks are required to hold only a fraction of their deposits as reserves, lending out the rest. This process of lending and re-depositing creates a multiplier effect. Understanding the money multiplier is crucial for policymakers, like the Reserve Bank of India (RBI), as it directly impacts the effectiveness of monetary policy tools in influencing economic activity. The recent liquidity injections by the RBI during and after the COVID-19 pandemic highlight the importance of understanding how these measures translate into broader economic impact through the money multiplier.
What is the Money Multiplier?
The money multiplier (k) represents the maximum amount of commercial bank money that can be created by each rupee of primary money (reserves). It is calculated as:
k = 1 / Reserve Ratio
Where the Reserve Ratio is the fraction of deposits banks are legally required to keep as reserves. For example, if the Reserve Ratio is 10% (0.1), the money multiplier is 10 (1/0.1). This means that an initial deposit of ₹100 can potentially lead to a ₹1000 increase in the money supply.
Factors Determining the Value of the Multiplier
1. Legal Reserve Ratio (LRR)
The LRR, mandated by the central bank (RBI in India), is the most significant determinant of the money multiplier. A higher LRR reduces the amount of money banks can lend, thus decreasing the multiplier. Conversely, a lower LRR increases the lending capacity and the multiplier effect. The RBI uses the LRR as a tool to control the money supply and inflation.
2. Excess Reserves
Banks may choose to hold reserves beyond the legally required amount, known as excess reserves. This is often due to caution during economic uncertainty or a lack of profitable lending opportunities. Higher excess reserves reduce the amount of money available for lending, lowering the multiplier. During periods of economic downturn, banks tend to hoard excess reserves, diminishing the multiplier effect of monetary policy.
3. Currency Drain Ratio (CDR)
The CDR refers to the proportion of deposits that people prefer to hold as cash rather than depositing them in banks. A higher CDR means less money is available for banks to lend, reducing the multiplier. Factors influencing CDR include public trust in the banking system, availability of alternative investment options, and seasonal demand for cash. In economies with a high preference for cash transactions, the CDR tends to be higher.
4. Foreign Exchange Rates & Foreign Currency Deposits
When individuals and businesses convert domestic currency into foreign currency and deposit it in foreign banks, it reduces the amount of money available in the domestic banking system. This leakage reduces the money multiplier. Similarly, inflows of foreign currency can increase the money supply and boost the multiplier. Fluctuations in exchange rates and global economic conditions can significantly impact this factor.
5. Interbank Lending and Borrowing
Banks often lend reserves to each other in the interbank market to meet short-term liquidity needs. This process can influence the overall level of reserves in the banking system and, consequently, the money multiplier. If banks are reluctant to lend to each other due to concerns about creditworthiness, it can reduce the effective multiplier.
Illustrative Example
Let's assume the LRR is 10% (0.1), the CDR is 20% (0.2), and banks hold no excess reserves. The effective money multiplier can be calculated as:
k = 1 / (LRR + CDR) = 1 / (0.1 + 0.2) = 1 / 0.3 = 3.33
This means that an initial deposit of ₹100 will ultimately lead to an increase in the money supply of approximately ₹333.
Limitations of the Money Multiplier
The simple money multiplier formula assumes a simplified banking system. In reality, the multiplier effect can be less potent due to factors like:
- Banks may not always lend out all available funds.
- Borrowers may not immediately spend all borrowed funds.
- The central bank can influence the money supply through other tools like open market operations.
Conclusion
The money multiplier is a crucial concept for understanding the relationship between central bank actions and the money supply. While the theoretical multiplier provides a useful framework, its actual value is influenced by a complex interplay of factors, including the reserve ratio, currency drain, and bank behavior. Policymakers must consider these factors when implementing monetary policy to achieve desired economic outcomes. The effectiveness of monetary policy hinges on accurately assessing and accounting for the real-world limitations of the money multiplier.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.