Model Answer
0 min readIntroduction
The concept of the money multiplier is central to understanding how commercial banks create money in an economy. It explains the relationship between the monetary base (controlled by the central bank) and the overall money supply. Closely related is the deposit multiplier, which focuses specifically on the expansion of deposits within the banking system. With the increasing prevalence of digital payment methods like credit and debit cards, the traditional mechanisms of money creation are being altered. This necessitates an examination of whether and how these changes affect the money multiplier, impacting monetary policy effectiveness.
Understanding the Multipliers
Both the deposit multiplier and the money multiplier are based on the fractional reserve banking system. Banks are required to hold a fraction of their deposits as reserves (the reserve ratio) and can lend out the rest. This lending process creates new deposits, leading to a multiplied expansion of the money supply.
The Deposit Multiplier
The deposit multiplier (k) is calculated as 1/reserve ratio (RR). It represents the maximum amount of new deposits that can be created by a single unit of initial deposit. For example, if the RR is 10% (0.1), the deposit multiplier is 10. This means that an initial deposit of ₹100 can potentially lead to a total increase in deposits of ₹1000 within the banking system.
The Money Multiplier
The money multiplier (m) is a broader concept than the deposit multiplier. It considers not only the reserve ratio but also the currency drain ratio (c), which represents the proportion of money people prefer to hold as cash rather than deposits. The formula for the money multiplier is: m = 1 / (RR + c). The currency drain ratio reflects the public’s preference for liquidity. A higher currency drain ratio reduces the money multiplier, as more money is held outside the banking system and is not available for lending.
Comparing the Deposit and Money Multipliers
The key difference lies in their scope. The deposit multiplier assumes all excess reserves are re-lent, while the money multiplier accounts for the leakage of funds from the banking system through currency holdings. Therefore, the money multiplier is always smaller than or equal to the deposit multiplier (m ≤ k). The deposit multiplier is a theoretical maximum, while the money multiplier reflects a more realistic scenario.
| Feature | Deposit Multiplier | Money Multiplier |
|---|---|---|
| Formula | 1 / Reserve Ratio | 1 / (Reserve Ratio + Currency Drain Ratio) |
| Currency Drain | Ignores | Considers |
| Value | Higher or Equal | Lower or Equal |
| Realism | Theoretical Maximum | More Realistic |
Impact of Credit and Debit Card Usage on the Money Multiplier
The massive use of credit and debit cards has a complex impact on the money multiplier. Traditionally, an increase in card usage was thought to reduce the money multiplier. Here’s why:
- Reduced Currency Drain: Credit and debit cards reduce the need for individuals to hold large amounts of cash. This decreases the currency drain ratio (c), potentially increasing the money multiplier.
- Shift in Bank Deposits: Transactions via cards often settle through bank accounts, increasing the volume of deposits. This could, in theory, increase the base for the multiplier effect.
- Impact on Reserve Requirements: Banks may be required to hold reserves against debit card transactions, depending on regulatory frameworks. This could increase the reserve ratio, decreasing the money multiplier.
- Velocity of Money: The increased speed and ease of transactions facilitated by cards increase the velocity of money (the rate at which money changes hands). A higher velocity of money can amplify the impact of the money supply on nominal GDP, even if the money multiplier remains constant.
However, the net effect is not straightforward. The rise of non-bank financial institutions (like payment processors) holding funds that were previously held as deposits in commercial banks can effectively reduce the amount of money available for lending by traditional banks, potentially offsetting the positive impact of reduced currency drain. Furthermore, the increasing sophistication of financial markets and the emergence of new financial instruments can also influence the money multiplier in unpredictable ways.
Recent research suggests that the relationship between digital payments and the money multiplier is becoming weaker as central banks adopt new monetary policy tools, such as quantitative easing (QE) and negative interest rates, which directly impact the monetary base and bypass the traditional multiplier mechanism. (Knowledge cutoff: 2023)
Conclusion
In conclusion, while the deposit multiplier represents the theoretical potential for deposit expansion, the money multiplier provides a more realistic view by accounting for currency holdings. The widespread adoption of credit and debit cards has a nuanced impact on the money multiplier, potentially reducing the currency drain ratio but also introducing complexities related to reserve requirements and the role of non-bank financial institutions. The effectiveness of the money multiplier as a tool for monetary policy is also being challenged by the evolving financial landscape and the adoption of unconventional monetary policies. Understanding these dynamics is crucial for effective macroeconomic management.
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.