Model Answer
0 min readIntroduction
The money multiplier is a key concept in macroeconomics, representing the magnified effect that an initial injection of funds into the banking system has on the overall money supply. Traditionally, it’s calculated as 1/Reserve Ratio. However, this is a simplified model. In reality, the public doesn’t deposit all of their money into banks (hoarding), and banks often choose to hold reserves exceeding the legally mandated minimum (excess reserves). These behaviors significantly impact the actual money multiplier, reducing its potential to expand the money supply. This answer will explain how these two factors – public hoarding and bank’s excess reserves – affect the money multiplier.
Understanding the Money Multiplier
The money multiplier (k) is calculated as: k = 1 / (Reserve Ratio + Cash Drain Ratio). The Reserve Ratio is the fraction of deposits banks are legally required to keep as reserves. The Cash Drain Ratio represents the proportion of money the public prefers to hold as cash rather than deposit in banks. A higher multiplier indicates a greater expansion of the money supply for a given increase in the monetary base.
Impact of Partial Hoarding by the Public
When the public engages in partial hoarding, it means individuals choose to hold a portion of their income as cash instead of depositing it into banks. This reduces the amount of money available for banks to lend out. Consequently, the Cash Drain Ratio increases.
- An increase in the Cash Drain Ratio directly lowers the money multiplier.
- For example, if the Cash Drain Ratio increases from 0.2 to 0.3, the multiplier decreases.
Impact of Excess Cash Reserve Holding by Banks
Banks are required to maintain a minimum reserve ratio set by the central bank (currently 4% in India as of knowledge cutoff 2023). However, banks often choose to hold reserves exceeding this minimum, known as excess reserves. This is done for precautionary motives, to meet unexpected withdrawals, or to avoid the costs associated with lending.
- Excess reserves reduce the amount of money banks have available to lend, effectively increasing the overall reserve ratio.
- A higher overall reserve ratio (including both required and excess reserves) lowers the money multiplier.
Combined Effect of Hoarding and Excess Reserves
When both partial hoarding and excess reserve holding occur simultaneously, the impact on the money multiplier is compounded. Both factors contribute to a larger denominator in the money multiplier formula (1 / (Reserve Ratio + Cash Drain Ratio)).
Let's illustrate this with an example:
| Factor | Initial Value | Revised Value |
|---|---|---|
| Reserve Ratio (Required) | 0.1 | 0.1 |
| Excess Reserve Ratio | 0 | 0.05 |
| Cash Drain Ratio | 0.2 | 0.1 |
| Total Reserve Ratio | 0.1 | 0.15 |
| Money Multiplier | 1 / (0.1 + 0.2) = 3.33 | 1 / (0.15 + 0.1) = 2.22 |
As the table demonstrates, the combined effect of a 5% excess reserve ratio and a 10% cash drain ratio significantly reduces the money multiplier from 3.33 to 2.22. This means that an initial injection of funds will have a smaller impact on the overall money supply than it would have in the absence of these factors.
Role of the Reserve Bank of India (RBI)
The RBI actively manages the money supply through various tools, including the Cash Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR). Changes in these ratios directly impact the reserve ratio and, consequently, the money multiplier. Furthermore, the RBI influences bank behavior through open market operations and policy interest rates, indirectly affecting excess reserve holding.
Conclusion
In conclusion, the theoretical money multiplier provides a useful framework for understanding the potential impact of monetary policy. However, real-world factors like public hoarding and banks’ preference for holding excess reserves significantly diminish the actual multiplier effect. Understanding these deviations from the simplified model is crucial for accurately assessing the effectiveness of monetary policy interventions and for formulating appropriate economic policies. The RBI must consider these factors when implementing monetary policy to achieve desired macroeconomic outcomes.
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.