Question

What do you expect to happen to the money multiplier as the economy moves into a deep recession? Explain assuming that the Fed does not adopt discretionary monetary policy to stimulate the economy.

Answer 1

When the economy moves into a recession, consumer confidence falls which makes people keep a higher proportion of money as currency with themselves instead of depositing it into commercial banks (due to uncertainty about future income). This increases currency drainage, and since Fed does not adopt any expansionary monetary policy to increase money supply, it decreases the value of money multiplier**.

**Money multiplier = (1 + cr) / (cr + er + rr) where

cr: Currency-deposit ratio (currency drainage),

er: Excess reserves ratio and

rr: Required reserves ratio

Therefore, the higher (lower) the value of cr, the lower (higher) the money multiplier.