The money multiplier is the amount of money that banks generate with each dollar of reserves. It represents the maximum extent to which the money supply is affected by any change in the amount of deposits. It equals ratio of increase or decrease in money supply to the corresponding increase and decrease in deposits. Thus, it can be said Money multiplier shows the mechanism by which reserve money creates money supply in the economy.
The
money multiplier effect arises due to the phenomenon of credit creation. When a
commercial bank receives an amount A, its total reserves are increased. The
bank is required by the central bank to hold only an amount equal to r × A in
hand to meet the demand for withdrawals, where r is the required reserve ratio.
The bank is allowed to extend the excess reserves i.e. (A − r × A) as loans.
When the borrower keeps the whole amount of loan in bank (it is assumed), it
increases its total reserves by an amount equal to (A − r × A). Again, the bank
is required to hold only a fraction of this second round of deposits and it can
lend out the rest. This cycle continues such the ultimate increase in money
supply due to an initial increase in checking deposits of amount A is equal to
m × A, where m is the money multiplier. The opposite happens in case of a
decrease in deposits through the same mechanism.
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Money Multiplier = |
1 |
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Required Reserve Ratio |