Define money multiplier and discuss its determinants. Explain in terms of money multiplier, how the banking system of an economy can control money supply.

Definition of Money Multiplier

The money multiplier (also known as the monetary multiplier) is the ratio of the money supply to the monetary base (high-powered money). It quantifies the maximum amount of broad money (M3) that commercial banks can create for a given fixed amount of base money (M0) and reserve ratio. The basic formula for the money multiplier (m) in a simplified model is:

Money Multiplier (m) = 1 / Reserve Ratio (r)

Where 'r' is the fraction of deposits that banks are required to hold as reserves. This formula highlights that the lower the reserve ratio, the higher the money multiplier, and vice-versa. The money multiplier effect is a direct consequence of fractional reserve banking, where banks leverage deposits to create new loans, which in turn become new deposits, expanding the money supply.

Determinants of Money Multiplier

While the simplified formula uses only the reserve ratio, in reality, the money multiplier is influenced by a more complex set of factors reflecting the behavior of the central bank, commercial banks, and the public. These can be broadly categorized as follows:

1. Reserve Requirements (Central Bank Policy)

• Cash Reserve Ratio (CRR): This is the percentage of a bank's Net Demand and Time Liabilities (NDTL) that it must hold as cash with the central bank. A higher CRR reduces the amount of money banks have available for lending, thus lowering the money multiplier. Conversely, a lower CRR increases lending capacity and the money multiplier.
• Statutory Liquidity Ratio (SLR): This is the percentage of NDTL that banks must maintain in liquid assets like cash, gold, or approved government securities. A higher SLR reduces the funds available for credit creation, thereby lowering the money multiplier.

2. Public's Behavior

• Currency Deposit Ratio (c): This refers to the ratio of money held by the public in currency to that held in bank deposits. If the public prefers to hold more cash outside the banking system (higher 'c'), less money is available for banks to lend, leading to a lower money multiplier. This often increases during festive seasons or periods of economic uncertainty.
• Time Deposit Ratio (t): This is the ratio of time deposits to demand deposits. If the public prefers to hold more in time deposits (Fixed Deposits, Recurring Deposits) which have lower liquidity, it affects the velocity of money and the overall multiplier, especially for narrow money (M1).

3. Commercial Banks' Behavior

• Excess Reserve Ratio (e): Banks may choose to hold reserves in excess of the legally required minimum (CRR). This decision is influenced by factors like the prevailing interest rates, demand for loans, and perceived risk in the economy. If banks hold higher excess reserves, it reduces their lending capacity and lowers the money multiplier.
• Lending Behavior and Credit Demand: Even if banks have excess reserves, the actual expansion of money supply depends on their willingness to lend and the public's demand for credit. During economic downturns, banks might be risk-averse, and credit demand might be low, limiting the multiplier effect.

4. Other Factors

• Monetary Policy Stance: The overall stance of the central bank (e.g., accommodative or tight) influences interest rates and liquidity, impacting the lending and borrowing behavior and, consequently, the money multiplier.
• Banking Habits and Financial Inclusion: Increased financial inclusion and a stronger banking habit among the public lead to more deposits, facilitating a larger money multiplier.

How the Banking System Controls Money Supply in terms of Money Multiplier

The banking system, primarily through the central bank (like the RBI in India) and commercial banks, controls the money supply by influencing the money multiplier and the monetary base. The relationship is expressed as:

Money Supply (M) = Money Multiplier (m) × Monetary Base (H)

Role of the Central Bank (RBI)

The RBI employs various monetary policy tools to manage the money multiplier and, by extension, the money supply:

• Adjusting Reserve Requirements:
  • Changing CRR: If the RBI wants to reduce the money supply (e.g., to control inflation), it can increase the CRR. This forces commercial banks to hold a larger fraction of their deposits as reserves with the RBI, reducing their capacity to lend and lowering the money multiplier. Conversely, a decrease in CRR expands lending capacity and increases the money multiplier, boosting money supply.
  • Changing SLR: An increase in SLR requires banks to hold more liquid assets, often government securities, reducing funds available for loans and credit creation, thereby decreasing the money multiplier and money supply. A reduction in SLR has the opposite effect.
• Open Market Operations (OMOs): The RBI buys or sells government securities in the open market.
  • Selling Securities: When the RBI sells government securities, commercial banks buy them, leading to a reduction in their reserves. This directly reduces the monetary base and, through the money multiplier, contracts the overall money supply.
  • Buying Securities: When the RBI buys government securities, it injects money into the banking system, increasing bank reserves (monetary base). This increased base is then multiplied through lending, expanding the money supply.
• Repo and Reverse Repo Rates: These policy rates influence the cost of borrowing for commercial banks.
  • Increasing Repo Rate: Makes borrowing from the RBI more expensive for commercial banks, discouraging lending, and potentially leading banks to hold more excess reserves, thus reducing the money multiplier effect and money supply.
  • Increasing Reverse Repo Rate: Encourages banks to park their excess funds with the RBI, reducing their lending capacity and thus the money supply.

Role of Commercial Banks

Commercial banks play a crucial role in operationalizing the money multiplier effect through their lending activities. When banks receive deposits, they retain the required reserves and lend out the excess. This loan becomes a deposit in another bank, which again retains reserves and lends out the rest, continuing the cycle. The extent to which commercial banks actively lend out their excess reserves directly impacts the realized money multiplier. During times of high credit demand and confidence, banks are more likely to lend, maximizing the multiplier. Conversely, during periods of low confidence or high risk, banks may prefer to hold excess reserves, weakening the multiplier effect.

In essence, the central bank sets the framework (reserve requirements, policy rates), and commercial banks operate within this framework, making lending decisions that collectively determine the actual expansion of the money supply through the money multiplier mechanism.