Question

2. Define M1 and M2

3. Describe the money multiplier and explain how it works.

Answer 1

2)

Money is divided into M1 and M2. Such division is made based on the liquidity. M1 is most liquid form of money supply while M2 is less liquid relative to M1.

M1 includes Cash and demand deposit.

M1 inlcudes M1 + Times deposits + Saving deposits + Money Market Mutual fund.

3)

Money Multiplier = Increase in Money supply / Monetary Base.

or 1/ reserve Ratio.

Suppose of if bank gets 1 million deposit and money supply is 5 million,

Money multiplier = 5/1

= 5

Value of multiplier depends on the reserve requirements.

When bank gets deposits, it keeps the certain part as reserve and lends out rest of money. While offering loans, new deposit account is created. There ,certain reserve is kept and rest of amount is given as loan. Same process continues. This is called process of money creation.