How is the money multiplier calculated
The money multiplier is a critical concept in banking and macroeconomics, as it helps to explain how banks create money through their lending practices. Simply put, the money multiplier measures the maximum amount of commercial bank money that can be created by a given unit of central bank money. In this article, we will explore the money multiplier concept, its calculation, and its implications for the broader economy.
Understanding the Money Multiplier
To calculate the money multiplier, we need to understand two essential concepts: reserve requirements and excess reserves. Reserve requirements are regulations set by central banks that dictate the minimum amount of cash reserves that commercial banks must hold against their customers’ deposits. Excess reserves refer to any cash holdings above this required minimum.
When a bank receives a new deposit, it can either hold onto the funds (as required or excess reserves) or lend them out to other customers. Loans create new deposits, which will be subject to further reserve requirements. This process continues with other banks and leads to an expansion of the money supply.
Calculating the Money Multiplier
The money multiplier is calculated using two key values: the reserve ratio (rr) and the currency ratio (cr). The reserve ratio refers to the portion of total deposits required to be held as cash reserves in a bank. The currency ratio represents the relationship between outstanding currency (notes and coins outside banks) and deposits.
The formula for calculating the money multiplier (MM) is:
MM = (1 + cr) / (rr + cr)
Here’s a step-by-step breakdown of how to calculate the MM using this formula:
1. Determine the reserve ratio: Check what percentage of total deposits a bank must hold as cash reserves based on central bank regulations.
2. Determine the currency ratio: Calculate the sum of outstanding currency divided by total deposits in an economy.
3. Plug in these values into the equation: Use the determined rr and cr values to find the money multiplier.
Suppose the reserve ratio is set at 10% (0.1) and the currency ratio in an economy is 0.2. In this case, the money multiplier would be calculated as follows:
MM = (1 + 0.2) / (0.1 + 0.2)
MM = 1.2 / 0.3
MM = 4
In this example, the money multiplier is 4, meaning that for every $1 of central bank money, commercial banks can potentially create up to $4 of new money through their lending process.
Implications for Monetary Policy
The money multiplier has significant implications for a country’s monetary policy, as central banks often influence the reserve ratio to control money supply growth and manage inflation levels. A higher reserve ratio would lower the money multiplier and limit the expansion of the money supply, while a lower reserve ratio would increase the multiplier and promote a more substantial increase in the money supply.
In conclusion, understanding the money multiplier is crucial in grasping how commercial banks create new funds by circulating central bank money through lending activities. Calculating the money multiplier involves determining both reserve and currency ratios within an economy and using these values in a straightforward formula that reveals their influence on potential new monetary creation.