Q.What is money multiplier? What determines the value of this multiplier?

The money multiplier indicates how much the money supply in an economy changes for a given change in the monetary base (high-powered money). It is the ratio of the total money supply ($M$) to the monetary base ($H$).

The money multiplier arises because banks create credit. When an initial deposit is made, a fraction is kept as reserves, and the rest is lent out. This lent amount is redeposited in the banking system, leading to further lending and deposit creation, expanding the money supply beyond the initial deposit.

The value of the money multiplier is determined by the following factors:

1. Reserve-Deposit Ratio ($r$): This is the fraction of deposits that commercial banks are legally required to hold as reserves (Cash Reserve Ratio - CRR) or voluntarily choose to hold. It includes both the Cash Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR).
   • Cash Reserve Ratio (CRR): The percentage of net demand and time liabilities that commercial banks must maintain as reserves with the central bank. A higher CRR means banks have less money to lend, reducing the credit creation capacity and thus decreasing the money multiplier. …

The money multiplier is a crucial concept in understanding how the central bank's actions, particularly regarding the monetary base, translate into changes in the overall money supply in an economy. It quantifies the extent to which the money supply expands for every unit increase in the monetary base (also known as high-powered money).

The economic intuition behind the money multiplier lies in the system of fractional reserve banking. When commercial banks receive deposits, they are not required to hold the entire amount as reserves. Instead, they are legally mandated to keep only a fraction of these deposits as reserves (either with themselves or with the central bank) and are free to lend out the remaining portion. When a bank lends money, the borrower typically deposits this money into another bank account, which then becomes a new deposit. This new deposit, in turn, allows the second bank to lend out a fraction of it, and the process continues. Each round of lending and redepositing creates new demand deposits, thereby expanding the money supply beyond the initial injection of high-powered money. This iterative process of deposit creation and lending is what gives rise to the multiplier effect.

The value of the money multiplier is determined by several factors, primarily related to the behavior of the public and commercial banks. These factors influence how much of the initial high-powered money gets converted into demand deposits and how much of those deposits banks can lend out.

The key determinants are:

• Currency-Deposit Ratio ($c$): This ratio represents the proportion of money that the public chooses to hold as physical currency relative to their demand deposits in banks.

  • Impact: A higher currency-deposit ratio means that for every rupee of high-powered money, a larger portion is held by the public as cash rather than being deposited in banks. When money is held as cash, it does not enter the banking system to be lent out, thus breaking the chain of deposit creation. Consequently, a higher currency-deposit ratio reduces the amount of funds available for banks to lend, leading to a smaller money multiplier. Conversely, a lower currency-deposit ratio means more money is deposited, allowing for greater credit creation and a larger multiplier.

• Reserve-Deposit Ratio ($r$): This ratio represents the proportion of total deposits that commercial banks are legally required to hold as reserves (known as the Legal Reserve Ratio or LRR, which includes the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)) or choose to hold as excess reserves. …