Question

Why does the money multiplier change if people hold cash? How does it change? If people start holding more cash now than they did in the past, is monetary policy more effective or less effective? Draw a graph to show this effect.

Answer 1

If people hold more cash deposits are reduced and currency in circulation is increased which increases C-D ratio. A higher C-D ratio is expected to reduce money multiplier as banks have fewer reserves to advance loans.

Since money multiplier is reduced, monetary policy is less effective in dealing with macroeconomic problems of recessionary and inflationary gap. A higher amount of monetary base is needed to change the money supply. This would imply that a higher money supply change brings a smaller change in interest rate. LM is steeper in this case.