Question

Explain the working of money multiplier with the help of a numerical example.

Hint:

Money Multiplier depends on the reserve ratio. Lower reserve ratio leads to a higher money multiplier and greater expansion of money supply.

Answer 1

Step 1: Meaning of Money Multiplier.
The money multiplier refers to the process through which the banking system creates multiple deposits from an initial deposit. It shows how a small increase in bank reserves can lead to a much larger increase in the total money supply in the economy.
Step 2: Formula of Money Multiplier.
The money multiplier is calculated using the formula:
\[ Money\ Multiplier = \frac{1}{Required\ Reserve\ Ratio} \]
Where the Required Reserve Ratio (RRR) is the fraction of deposits that banks must keep as reserves with the central bank.
Step 3: Numerical Example.
Suppose the required reserve ratio is \(10%\) (0.10). If a person deposits \(₹1000\) in a bank, the bank must keep \(₹100\) as reserves and can lend \(₹900\).
Step 4: Deposit Expansion Process.
The \(₹900\) loan will be deposited in another bank. That bank will keep \(₹90\) as reserves and lend \(₹810\). This process continues multiple times, creating additional deposits in the banking system.
Step 5: Total Money Creation.
Using the formula:
\[ Money\ Multiplier = \frac{1}{0.10} = 10 \]
Therefore, the total potential increase in money supply from an initial deposit of \(₹1000\) is:
\[ 1000 \times 10 = ₹10000 \]
Thus, the banking system can create up to \(₹10000\) in total deposits from the initial deposit of \(₹1000\).