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Money Multiplier, also known as the monetary multiplier, is described as a process in which money is created in an economy through credit creation based on a fractional reserve banking system. It is expressed as the total extent to which changes in the quantity of money deposited affect the money supply. The money multiplier effect is mostly seen in commercial banks as they collect deposits and then keep the money as a reserve before distributing the money as loans to infuse liquidity into the economy. The money that is reserved by commercial banks for withdrawal purposes by the customers is defined as the reserve ratio which is also known as the required reserve ratio or cash reserve ratio.
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Key Terms: Money Multiplier, Monetary Multiplier, Commercial Banks, Reserve Ratio, Legal Reserve Ratio, Statutory Liquidity Ratio, Money Supply, Monetary Base
What is Money Multiplier?
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Money Multiplier is a term that calculates the amount of money generated by banks using deposits after subtracting the amount set aside for reserves. It indicates how many times the sum will be increased in response to a certain change in the deposits. The money multiplier and the legal reserve ratio have an inverse relationship. A legal reserve ratio refers to the number of deposits that banks are expected to have on hand as reserves at all times in order to face unforeseen circumstances and retain public confidence.
There are two varieties of reserves that the banks need to maintain:
- Cash Reserve Ratio: Cash Reserve Ratio (CRR) is the reserves that banks are required to keep with the central bank.
- Statutory Liquidity Ratio: Statutory Liquidity Ratio (SLR) shows the number of reserves that the banks are needed to keep up within the sort of assets themselves. The money number formula works as an excellent tool in the financial economy for the financial organizations to manage the money creation process as a result of its working as a complete funds formula that's used for calculating the money supply.
Read More: GDP Formula- Income and Expenditure Method
Money Multiplier Formula
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The monetary multiplier formula, or money multiplier formula, can be mathematically represented as,
Money Multiplier = 1/r
where r denotes the reserve ratio or cash reserve ratio
We can also describe the money multiplier as,
Money Multiplier = 1/LRR
where LRR stands for Legal Reserve Ratio
The reserve ratio is defined as the legal minimum ratio that commercial banks must maintain in order to keep deposits with themselves. It is the total amount of money that should be retained in commercial banks' reserves for customer withdrawal purposes. This is also applicable to India's central bank, the Reserve Bank of India (RBI).
Banks create the money supply by receiving deposits, retaining a portion as reserves, and lending the remainder. In simple terms, a money multiplier is the highest quantity of money that can be created through this type of banking.
Money Multiplier Formula
Read More: Disposable Income Formula
Money Multiplier Formula: Example
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Let us understand the money multiplier formula with the help of an example.
There is an initial deposit of Rs.10,000 into the bank. The LRR that has to be maintained by the commercial banks is given as 20%. The bank is solely responsible for all the payments and deposits and keep only the minimum balance of LRR and lend the rest of the money to the customers.
Ans. Money Multiplier Formula = 1/LRR
Money multiplier = 1/20%
Money multiplier = (1/0.20) x 100
Money multiplier = 5 times
This means that the initial deposit of Rs.10,000 will be increased up to 5 times excluding the reserves. The table mentioned below will explain the process:
| S.No. | Deposits | Loans | LRR @20% |
|---|---|---|---|
| Initial Deposit | 10,000 | 8,000 | 2,000 |
| 1st | 8,000 | 6,400 | 1,600 |
| 2nd | 6,400 | 5,120 | 1,280 |
| 3rd | 5,120 | 4,096 | 1,024 |
| 4th | 4,096 | 3,276.8 | 819.20 |
| 5th | 3,276.8 | 2,621.44 | 655.36 |
| Total | 50,000 | 40,000 | 10,000 |
The initial deposit of Rs. 10,000 is done into the bank, and as the banks are required to maintain 20% of the deposits, thus, the bank has to maintain 20% of Rs. 10,000 i.e. Rs. 2,000 with itself and can lend the rest of the money i.e. Rs. 8,000 as loans to the consumers/public. This process will continue again and again till the value of deposits does not become Rs. 50,000. The value of the money multiplier is 5 times, which means the process will continue till the initial deposits increase to Rs. 50,000.
Read More: Average Revenue Formula
Money Multiplier Equation
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The monetary multiplier equation or money multiplier equation can be mathematically represented as,
Money Multiplier = Change In Total Money Supply / Change In the Monetary Base
The equation is also known as Credit Multiplier Formula. The increase in the Legal Reserve Ratio leads to a decrease in the money multiplier because commercial banks will have to hold larger reserves, resulting in less money available to lend to the public.
Money Multiplier Equation
Things to Remember
- A monetary multiplier or money multiplier is a process in which money is created in an economy through credit creation based on a fractional reserve banking system.
- Money Multiplier can also be described as the total extent to which changes in the quantity of money deposited affect the money supply.
- The monetary multiplier formula, or money multiplier formula, can be mathematically represented as Money Multiplier = 1/r or 1/LRR
- The reserve ratio is defined as the legal minimum ratio that commercial banks must maintain in order to keep deposits with themselves.
- The monetary multiplier equation, or money multiplier equation, can be mathematically represented as Money Multiplier = Change in total money supply/ Change in the monetary base.
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Sample Questions
Ques. A sum of Rs. 20,000 is deposited in the bank. The Legal Reserve Ratio (LRR) of 10% is required to be kept by commercial banks. The bank is where all payments and deposits are made. Banks merely maintain the bare minimum of the legal reserve ratio and lend the remainder to the general public. What will be the money multiplier? (5 Marks)
Ans. We can calculate the money multiplier by using the formula
Money Multiplier = 1/LRR
Here, the legal reserve ratio (LRR) is 10%.
Money Multiplier = 1/10%
= 1/10 * 100
= 10 times
It implies that, excluding the reserves, the initial deposit of Rs. 20,000 will be increased up to 10 times.
Let's see the detailed process in the table given below
| S.No. | Deposits | Loans | LRR @ 10% |
|---|---|---|---|
| Initial Deposit | 20,000 | 18,000 | 2,000 |
| 1st | 18,000 | 16,200 | 1,800 |
| 2nd | 16,200 | 14,580 | 1,620 |
| 3rd | 14,580 | 13,122 | 1,458 |
| 4th | 13,122 | 11,809.8 | 1,312.2 |
| 5th | 11,809.8 | 10,629 | 1,180.98 |
| 6th | 10,629 | 9,556.1 | 1,062.9 |
| 7th | 9,556.1 | 8609.49 | 956.61 |
| 8th | 8609.49 | 7748.541 | 860.949 |
| 9th | 7748.541 | 6,973.6869 | 774.8541 |
| 10th | 2,00,000 | 1,80,000 | 20,000 |
This method will be repeated until the initial deposits reach Rs 2,00,000. Because the money multiplier is 10, the number of initial deposits of Rs. 20,000 will grow to Rs. 2,00,000 by the end.
Ques. What is the difference between the money multiplier and the deposit multiplier? (3 Marks)
Ans. The money multiplier and the deposit multiplier are closely linked and are frequently used similarly. The deposit multiplier is the first step in creating money, and it also serves as a foundation for the money multiplier, which tells us how many times the amount can be increased in response to changes in deposits. Because of the extra reserves, the credit multiplier formula yields a lower value than the deposit multiplier calculation.
Ques. Describe the multiplier effect in detail. (3 Marks)
Ans. The multiplier effect is a phenomenon that causes a proportional increment or decrement in ultimate income as a result of an addition or withdrawal of capital. It is extremely helpful in determining the influence of changes in various economic activities, such as spending or investment, on total economic production. The multiplier effect can be mathematically represented as,
Multiplier = Change in Income/Change in Expenditure
Ques. A bank has a required reserve ratio of 25%, calculate the money multiplier of the economy? (3 Marks)
Ans. We know that
Money Multiplier = 1 / Required Reserve Ratio
Money Multiplier = 1/25% = 1/0.25
Money Multiplier = 4
Thus, the money multiplier of the economy is 4.
Ques. Describe the fiscal multiplier in brief. (3 Marks)
Ans. The fiscal multiplier is a measurement of the effect of increased fiscal spending on the gross domestic product (GDP) or the nation's economic output. In general, economists describe the fiscal multiplier as the ratio of a change in output to a change in tax income or government spending. In layman's terms, it calculates the effect of fiscal stimulus on the Gross Domestic Product (GDP).
Ques. What is income determination? Explain its significance in economics. (3 Marks)
Ans. The income determination phenomenon is defined as the point at which the equilibrium income level is determined when aggregate demand equals total output and investment equals savings. In layman's words, it depicts the process of determining an economy's equilibrium level of income. Expenditure, investment, savings, and expenditure are the three main activities involved.
Ques. Commercial Banks in a country maintain a reserve equivalent to 20% of their deposits. What will be the money multiplier and the total money supply in the economy if the total deposits are given as $20 million. (3 Marks)
Ans. We know that, Money Multiplier = 1 / Required Reserve Ratio
Money Multiplier = 1 / 20% = 1/0.20
Money Multiplier = 5
Now, Total Money Supply = Money Multiplier x Total Deposits
Total Money Supply = 5 x $20 million
Thus, Total Money Supply = $100 million
Ques. Mention the implementation of the multiplier formula? Explain in detail. (3 Marks)
Ans. The money multiplier is an important part of the country's monetary policy, and it functions as a total amount of money supply formula for computing money supply. With this in the economy, the central bank can manage credit creation. The central bank will cut the legal reserve requirements (LRR) if it wants to boost the money supply in the market, and it will increase the LRR if it wants to limit the money supply.
Ques. What is a multiplier in economics? Explain. (3 Marks)
Ans. This economic element is referred to as the multiplier in the economic language since it causes changes in several other related economic variables. This multiplier word is used to describe the link between total national revenue and government spending. When it comes to the gross domestic product (GDP), this causes changes in total output that are higher than the change that created it.
Ques. What is the money supply reserve multiplier? Explain. (3 Marks)
Ans. The money multiplier in terms of reserve dollars by many economists, and the money multiplier formula is dependent on that. The multiplier effect can be mathematically represented as,
Multiplier = Change in Income/Change in Expenditure
Ques. How can we calculate the deposit multiplier? (3 Marks)
Ans. The fractional reserve banking system determines the basic mechanism of money supply creation, which is known as the deposit multiplier.
The deposit multiplier can be calculated by using the following formula,
Deposit Multiplier = 1/ Required Reserved Ratio
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