Money Multiplier: Concept and Formula

In the realm of economics, the term “multiplier” is broadly used to refer to an economic factor that, when changed, leads to a change in many other related economic variables.

The money multiplier is one of the monetary parts of economics. It is a phenomenon for creating money in the economy in the form of credit creation. This way of creation of money is based on the reserve banking system. Another name of the money multiplier is the monetary multiplier.

One place where you can see the money multiplier effect is the commercial banks. Commercial banks accept deposits, and after they keep as a reserve, they give away the rest in the form of loans. This is the way that they contribute to maintaining liquidity in the economy.

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Define Money Multiplier

Money Multiplier is defined as how an initial deposit can lead to a bigger final increase in the total money supply or we also can say how much money can be generated with the help of available resources in the economy.

Money Multiplier Formula

If you want to calculate the money multiplier, you will need to use the formula. Once you use the money multiplier formula, you will be able to use it every time you want to know the value of the monetary multiplier.

However, before you start calculating the money multiplier, you will need to understand the concept of the cash reserve ratio. The cash reserve ratio is an essential part of a bank. The cash reserve ratio is a specific part of the Reserve Bank of India (RBI). CRR is the way that the banks ensure that they never run out of money. The cash reserve ratio is the way that you can calculate the money multiplier. Under the policy of the cash reserve ratio (CRR), the commercial banks have to keep certain amounts as reserves with the Reserve Bank of India. The percentage of reserve which is required to be kept will be against the bank’s total deposits. The banks can choose where they want to keep the cash reserve ratio, as they can keep it in two places.

Here is how to calculate money multiplier using the formula:

Money multiplier = \[\frac{1}{r}\]   

The ‘r’ in the formula refers to the cash reserve ratio or the required reserve ratio. This is the derivation of a money multiplier.

Example: SDE bank keeps a reserve ratio of 10% (0.1). If person A deposits \[\$\]100, SDE bank will keep \[\$\]10 as a reserve from the deposit and then lend out \[\$\]90. The other banks will see the \[\$\]90 as future deposits. Hence, the process of lending out deposits starts again.

In the example, the process stops at the Tenth Bank. However, in theory, the process continues till money multiplier deposit is fractionally very small. 

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When the process is repeated an infinite number of times, the final deposit would be  \[\$\]1000.

Money Multiplier = \[\frac{1}{0.1}=10\]

Increase in Money Supply = 10 \[\times\$\]100= \[\$\]1000 

In the above example and table, we can see that with initial deposits of 100 along with 10% of reserves the banks will be able to create money at the end of about  \[\$\]1000 in the market. This is how a money multiplier works.

Examples of Money Multiplier Effect

Example 1: ABC bank has a required reserve ratio of 25%. Calculate the money multiplier of the economy.

Solution:  Reserve ratio = 25% 

Money Multiplier=  \[\frac{1}{r}\]

Money Multiplier=  \[\frac{1}{25}\times 100\]

Money Multiplier=  4

Example 2: The central bank of country XYZ has passed a policy that required the commercial banks to maintain a reserve of 20% of their deposits. Calculate the money multiplier of the economy. 

Solution: Reserve ratio: 20 %

Money multiplier = \[\frac{1}{r}\]

Money multiplier =  \[\frac{1}{20}\times 100\]

Money multiplier= 5

Money Supply Multiplier Effect

Economists and bankers often look at the multiplier effect from the lens of banking and a nation’s money supply. This particular multiplier is known as the money supply multiplier or simply the money multiplier. This multiplier involves the reserve requirement set by the Board of Governors of the Federal Reserve System. It differs depending on the number of liabilities held by a particular depository institution.

How this works is when a customer deposits money into a short-term deposit account, the banking institution is allowed to lend one minus the reserve requirement to another entity. The original depositor continues to maintain the ownership of the amount that they have created in the bank, the funds that are created through lending the initial funds. 

Now, suppose a second borrower decides to deposit the funds received from the lender. In that case, this leads to an increase in the value of the money supply, despite there being no physical currency that exists to support the new amount.

Money Multiplier is a concept that is important for an individual to know and understand. If you are learning about the concept of banking, the functions of commercial banks and the relationship between commercial banks and central banks, it is very important that you know about money multipliers. Many banks offer money multiplier fd or fixed deposit to their customers when they are investing.