How Does CRR Affect the Money Multiplier in Banking?
The money multiplier is a fundamental concept in macroeconomics, especially within banking and monetary policy. It describes how an initial deposit can lead to a multiplied expansion of the total money supply in an economy. This process occurs because commercial banks only keep a part of deposited money as reserves and lend out the rest, setting off a chain reaction of deposits and lending across the banking system.
Meaning and Process of Money Multiplier
When a bank receives a deposit, it keeps a certain percentage (reserve ratio) as reserves as per central bank requirements. The remaining portion is lent out, and these funds are typically redeposited in banks by the borrowers or other parties. Banks again repeat this process—keeping a fraction as reserves and lending out the rest. This ongoing cycle of lending and depositing causes the initial sum to be “multiplied,” increasing the total money supply much more than the initial deposit amount.
Money Multiplier Formula
The expansion of money due to the banking system can be measured by the money multiplier. The formula is straightforward:
Here, the reserve ratio is the fraction of each deposit that banks are required to keep in reserve and not lend out. A lower reserve ratio leads to a higher multiplier, and vice versa.
Step-by-Step Example
Suppose the reserve ratio is 10% (0.10). If someone deposits INR 1,000 in Bank A:
- Bank A keeps INR 100 as reserves and lends INR 900.
- The INR 900 is deposited by someone else into Bank B.
- Bank B keeps INR 90 as reserve (10% of 900) and lends out INR 810.
- This process repeats across banks, with each round creating new deposits and loans.
Through this continuous lending and redepositing, the initial INR 1,000 deposit can ultimately expand to a total money supply of INR 10,000 (since 1/0.10 = 10 times the original deposit).
| Reserve Ratio (%) | Money Multiplier | Total Potential Money from INR 1,000 |
|---|---|---|
| 5 | 20 | INR 20,000 |
| 10 | 10 | INR 10,000 |
| 20 | 5 | INR 5,000 |
Key Principles and Definitions
- Money Multiplier: The ratio that shows how much total new money can be created in the economy for every unit of money initially deposited.
- Reserve Ratio: The percentage of deposits that a bank must keep aside as reserves.
- Total Money Supply Impact: A decrease in the reserve ratio raises the money multiplier, increasing the total money supply; an increase in reserve requirement results in a smaller multiplier, limiting money creation.
Applications and Significance
The money multiplier is crucial for central banks and governments in managing a country’s monetary policy. Here are some applications:
- Monetary Policy: Central banks can adjust the reserve ratio to influence overall credit creation and liquidity in the economy.
- Credit Generation: Enables economic growth by boosting credit availability for investments and consumption.
- Financial Stability: Helps explain how too much or too little credit can lead to inflation, deflation, or financial instability.
- Policy Making: Used in strategy to forecast the effects of changes in policies on money supply and the broader economy.
| Factor | Effect on Money Multiplier |
|---|---|
| Lower Reserve Ratio | Increases the money multiplier and money supply |
| Higher Reserve Ratio | Decreases the money multiplier and money supply |
| Public Preference to Hold Cash | Reduces the impact of the multiplier in the real world |
| Banks' Willingness to Lend | The more banks lend, the greater the multiplier effect |
Step-by-Step Approach for Solving Problems
- Identify the reserve ratio given in the question.
- Convert the reserve ratio to its decimal form (e.g., 10% = 0.10).
- Use the formula: Money Multiplier = 1 / Reserve Ratio.
- Multiply the money multiplier by the initial deposit to estimate the total potential expansion in money supply.
Conclusion and Next Steps
Understanding the money multiplier builds your foundation for banking, monetary policy, and overall economic analysis. It is directly linked to concepts like credit creation, bank reserves, and policy instruments of the central bank. Mastering this topic helps you to analyze changes in banking rules and their impact on the broader economy.
To deepen your understanding and practice more problems, explore specialized resources and live commerce classes available at Vedantu Commerce Courses. Strengthen your concept mastery and prepare for advanced economic subjects with expert-led sessions and practice questions.
FAQs on Money Multiplier Explained: Meaning, Formula & Application
1. What is the money multiplier?
The money multiplier is the ratio that measures how much the total money supply increases from an initial injection of high-powered money (base money) in an economy. It shows how commercial banks create additional money through lending, based on the reserves they are required to keep.
2. What is the formula of money multiplier?
The standard formula for the money multiplier is: Money Multiplier (mm) = 1 / CRR, where CRR is the Cash Reserve Ratio expressed in decimal form. For example, if CRR = 10% (0.10), then money multiplier = 1/0.10 = 10.
3. How does CRR affect money multiplier?
CRR (Cash Reserve Ratio) and money multiplier are inversely related.
- If CRR increases, banks must keep a higher portion of deposits as reserves, so the money multiplier decreases.
- If CRR decreases, banks can lend more, increasing the money multiplier.
4. What is high-powered money?
High-powered money (also called base money or reserve money) is the total currency in circulation plus banks' reserves with the central bank. It acts as the foundation for the entire money supply multiplied through the banking system.
5. How to calculate total money supply using the money multiplier?
Total Money Supply (M) is calculated as: Money Supply = Money Multiplier × High-Powered Money (M = mm × H).
For example, if mm = 5 and H = ₹2,00,000, then M = 5 × ₹2,00,000 = ₹10,00,000.
6. What is the difference between money multiplier and credit multiplier?
The money multiplier measures the increase in total money supply from base money, while the credit multiplier shows only the increase in demand deposits created by bank lending.
- Money multiplier = 1/CRR
- Credit multiplier = (1/CRR) – 1
7. What are the factors affecting the money multiplier?
Key factors influencing the money multiplier include:
- Cash Reserve Ratio (CRR) set by the central bank
- Statutory Liquidity Ratio (SLR)
- Currency-deposit ratio (preference of public for cash over deposits)
- Banking habits and willingness of banks to lend
8. What are the assumptions of the money multiplier theory?
The money multiplier theory assumes:
- Banks lend all excess reserves
- The public does not withdraw cash suddenly or hold extra cash
- CRR is strictly followed by all banks
9. Why is the money multiplier important in monetary policy?
The money multiplier helps central banks:
- Predict how changes in reserve requirements affect the money supply
- Control inflation and liquidity by influencing lending
- Design effective monetary policy by understanding the credit creation capacity of banks
10. What is the typical value of the money multiplier if CRR is 10%?
If CRR is 10% (0.10), the formula gives:
Money Multiplier = 1/0.10 = 10. This means every ₹1 of high-powered money can generate up to ₹10 in total money supply.
11. How does the money multiplier process actually work in banking?
The process works as follows:
- A deposit is made in a bank; a portion is kept as reserve (CRR), and the rest is lent out.
- The lent money is spent and redeposited at another bank, which repeats the process.
- This cycle continues, creating multiple rounds of money supply, resulting in a multiplier effect.
12. What are the limitations of the money multiplier?
Limitations include:
- People may prefer to hold cash rather than deposits, reducing multiplier effect.
- If banks hold excess reserves or limit lending, the actual multiplier is lower.
- Sudden withdrawals, financial panic, or policy changes can disrupt the expected multiplier outcome.
