Question

2. Explain in detail how the money multiplier process works.                       

Answer 1

Money multiplier is the process through which banks generate money. The primary function of the bank is to accept deposits and lend money through loans. Amount of money created/generated by banks with every dollar amount of reserves is money multiplier. For this purpose, reserves are the percentage of deposits which the Federal Reserve requires the banks to hold with themselves thereby meaning that these reserves cannot be lent out.

The formula to calculate money multiplier is given by:

Hence, if the reserve ratio is say 10%, the money multiplier will be 10 times. Hence, increase in money supply is given by following equation:

Where,

m     denotes Money multiplier

M.B denotes Monetary Base (Deposit)

This can be explained with the help of an example:

Suppose the reserve ratio is 10%, initial deposit of $200 is made with the bank, which implies that the bank will keep 10% of $200 that is $20 as reserves and lend out $180 as loans and so on.

Once the bank has extended $180 as a loan, the same amount is deposited with the bank in stage 2. Again a reserve of 10% is kept by the bank and the remaining amount is lent out. This process of money multiplier goes on until the deposits are fractionally very small.

One thing to note is that, the higher the reserve ratio requirements by Fed, the lower will be the money multiplier as less deposits will be available for lending.