Question

How does an increase in the currency-to-deposits ratio affect the size of the money multiplier? How does an increase in the reserve-deposit ratio (rr) affect the size of the money multiplier?

Answer 1

The money multiplier is defined as mm= (1+cu)/(cu+re),

where cu= CU/D = currency-deposit ratio, and re = R/D = Reverse Deposit Ratio.

An increase in the currency- deposit ratio means that people hold more currency and banks have fewer funds to create deposits. An Increase in deposit rates will induce depositors to deposit more, thereby leading to a decrease in Cash to aggreate deposit ratio. This will in turn lead tp rise in Money Multiplier.

The multiplier effect describes how an incrase in one economic activity leads to a much greater increase in economic output. In the banking system money that gets deposited multiplies as it filters through the economy going from depositor to borrower multiple times.

Now, the reserve ratio represents the fraction of a customer's deposits that a bank is required to withhold on reserve in their vault or on deposit with the central bank. for example, when the reserve ratio is ten percent, that means ten percent af all new totak reserves are required to be reserved by the bank.

In other words, this means the smaller the Reserve-ratio is, the largber the increase it brings to the money supply, because more of the customers deposits get loned out by the bank. For example, when reverse ratio is 0.25 that means the money multiplier is 4.