Question

Invoke the money multiplier framework to show in words and with the aid of algebra that the central bank's ability to control the quantity of money in the economy is limited.

Answer 1

The money multiplier will depend on the proportion of reserves that banks are required to hold by the Federal Reserve Bank. Additionally, a bank can also choose to hold extra reserves. Banks may decide to vary how much they hold in reserves for two reasons: macroeconomic conditions and government rules. When an economy is in recession, banks are likely to hold a higher proportion of reserves because they fear that loans are less likely to be repaid when the economy is slow. The Federal Reserve may also raise or lower the required reserves held by banks as a policy move to affect the quantity of money in an economy, as Monetary Policy and Bank Regulation will discuss.

The process of how banks create money shows how the quantity of money in an economy is closely linked to the quantity of lending or credit in the economy. Indeed, all of the money in the economy, except for the original reserves, is a result of bank loans that are re-deposited and loaned out, again, and again.

Finally, the money multiplier depends on people re-depositing the money that they receive in the banking system. If people instead store their cash in safe-deposit boxes or in shoeboxes hidden in their closets, then banks cannot recirculate the money in the form of loans. Indeed, central banks have an incentive to assure that bank deposits are safe because if people worry that they may lose their bank deposits, they may start holding more money in cash, instead of depositing it in banks, and the quantity of loans in an economy will decline. Low-income countries have what economists sometimes refer to as “mattress savings,” or money that people are hiding in their homes because they do not trust banks. When mattress savings in an economy are substantial, banks cannot lend out those funds and the money multiplier cannot operate as effectively. The overall quantity of money and loans in such an economy will decline.

Money and banks are marvelous social inventions that help a modern economy to function. Compared with the alternative of barter, money makes market exchanges vastly easier in goods, labor, and financial markets. Banking makes money still more effective in facilitating exchanges in goods and labor markets. Moreover, the process of banks making loans in financial capital markets is intimately tied to the creation of money.

But the extraordinary economic gains that are possible through money and banking also suggest some possible corresponding dangers. If banks are not working well, it sets off a decline in convenience and safety of transactions throughout the economy. If the banks are under financial stress, because of a widespread decline in the value of their assets, loans may become far less available, which can deal a crushing blow to sectors of the economy that depend on borrowed money like business investment, home construction, and car manufacturing. The Great Recession of 2008–2009 illustrated this pattern.

Money Multiplier =1/ Required Reserve Ratio)

The required reserve ratio is the fraction of deposits which a bank is required to hold in hand. It can lend out an amount equals to excess reserves which equal (1 − required reserves).

Higher the required reserve ratio, lesser the excess reserves, lesser the banks can lend as loans, and lower the money multiplier. Lower the required reserve ratio, higher the excess reserves, more the banks can lend, and higher is the money multiplier.
In the above relationship, it is assumed that there is no currency drainage, i.e. the borrowers keep 100% of the amount received in banks.

It will be useful to know as to why we should understand this ratio. This is simply because, if this ratio moves up, it is an indication of the fact that the banking system in the country is generating a higher quantum of the money supply from the money that is provided by the RBI. One of the key reasons this is happening is due to a continuous and persistent decline in the cash holdings with individuals that we have seen in recent years. This can be attributed to the agenda of financial inclusion that the country has been driving for several years now. The ‘shout’ on financial inclusion is leading people to hold less cash, in relation to the deposits, which is resulting in an increased multiplier.

There are primarily two factors that affect the money supply. One is how much cash do individuals and businesses hold as cash in hand and the other being quantum of money that banks hold as reserves.

As regards the first one, the higher the cash that the individuals and businesses hold in hand, the lesser would be the ability of the banking system to create money and hence a lower multiplier. Conversely, the lower the cash in hand with individuals and businesses (which means, they have placed a higher amount in say savings and deposits), the higher would be the ability of banks to multiply that money. In a way, cash-in-hand acts as a leakage as far as the banking system is concerned. As regards the second one, if the reserves that the banks hold with Central Bank is high, the lower would be the multiplier and vice versa.

The increase in India’s money multiplier is more due to the former (holding less cash in hand) and less on account any decline in reserves with Central Bank. The agenda of financial inclusion that has been driven by different governments has resulted in an increasing number of bank accounts. This has led to more money moving into banks as savings and deposits. And further banks have been able to convert the RBI money into money for commercial activities in the economy more efficiently.