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Money MultiplierMoney Multiplier

By Laxmi Narasimha Boddu

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AssumptionsAssumptions

x Depositors always leave their money in bank deposits.

x Individuals and banks in the aggregate always hold a certain fraction of their

´moneyµ in terms of currency and deposit reserves respectively.

x As per above assumption reserves in bank is in two forms

x Reserves (R),As per regulatory body rules (RBI in India)

x Excess reserves (E), available for lending.

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DefinitionsDefinitions

y Monetary Base ² B

The total number of rupees held by the public as currency and by thebanks as reserves

B=C+R+E ------(1)

y Reserve-deposit ratio

Reserve ratio rr = R/D

Excess reserve ratio er = E/D

y Currency-deposit ratio ² cr

Amount of currency C people hold as a fraction of their holdings of Demand deposit D

cr = C/D

y Money M is in the form of Deposits and Currency

M = C+D -------(2)

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DerivationDerivation

Using equation 1 & 2

 D E 

 D R

 DC 

 D D

 DC 

 B

 M 

!

 E  RC 

 DC 

 B

M 

!

er rr cr 

cr 

 B

M 

!

1

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Money MultiplierMoney Multiplier

 B M er rr cr 

cr  *1

!

er rr cr 

cr 

1

-----(3)

Factor of proportionality denoted by ́ mµ

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High Powered moneyHigh Powered money

y From Equation 1 & 3

Each rupee of money base produces ́ mµ

rupees of money.

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y As money base increases Money supply increases.

y As rr decreases Money supply increase.

y As cr decreases Money supply increases.

 

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Can this single factor can cause depression in

economy?

 

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Banks Failure and the money SupplyBanks Failure and the money Supply

in the 1930sin the 1930s

y Monetary base rose 18%

y

More than 9000 banks failed in betweenA

ugust 1929and March 1933

y Money supply fell 28%

y Money multiplier fell 38%

Reasons

x Currency ² deposit ratio

x Reserve ² deposit ratio

 

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Money supply and its determinants:Money supply and its determinants:

1929 and 19331929 and 1933August 1929 March 1933

Money Supply

Currency

Demand deposits

26.5

3.9

22.6

19.0

5.5

13.5

Monetary base

Currency

Reserves

7.1

3.9

3.2

8.4

5.5

2.9

Money Multiplier 

Reserve-deposit ratio

Currency-deposit ratio

3.7

0.14

0.17

2.3

0.21

0.41

 

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PreventionsPreventions

y Lender of last resort

y Monetary base increase

 

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Thank YouThank You