Define money multiplier and discuss its determinants. Explain in terms of money multiplier, how the banking system of an economy can control money supply.
The money multiplier explains how an initial change in the monetary base (high-powered money: currency in circulation plus bank reserves) leads to a larger change in the overall money supply. It is the ratio of total money supply to the monetary base. For instance, a multiplier of 5 means every one rupee increase in the base generates a five-rupee increase in money supply.
Its main determinants are:
- Reserve-Deposit Ratio (r): The fraction of deposits banks hold as reserves. A lower ratio allows more lending, raising the multiplier, while a higher ratio reduces it.
- Currency-Deposit Ratio (c): The share of money the public holds as cash versus deposits. More cash holding lowers deposits and lending capacity, reducing the multiplier; preference for deposits increases it.
The central bank manages the money supply by influencing both the monetary base and these ratios. Key tools include:
- Open Market Operations (OMOs): Buying securities injects reserves, expanding the base; selling withdraws reserves.
- Repo/Reverse Repo Rates: Adjusting short-term rates influences banks’ incentives to hold reserves, affecting lending.
- Cash Reserve Ratio (CRR): Directly sets the legal reserve requirement. A lower CRR raises the multiplier, while a higher CRR contracts it.
Through these mechanisms, the central bank controls the monetary base and shapes the behavior of banks and the public. The money multiplier effect amplifies these changes, making it a crucial link in monetary policy and money supply management.
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