Question

1. What is the money multiplier? Give the formula and the number for the above scenario.  How is M1 affected as a result of my deposit once all the steps have played out?  What would the multiplier be if the required reserve ratio was 20%?  How would things be different if banks liked to hold excess reserves? Would that increase or decrease the amount of money created?
2. Explain the process of money creation by banks for a scenario where the required reserve ratio is 10% and I deposit $1000 of cash in my banks.  Describe a few rounds of loan creation assuming that no bank holds any excess reserves.

Answer 1

Answer - Money multiplier refers to the maximum amount that can be created by the deposits of the banks through the lending process. Assume that the initial deposits are $ 1000 and reserve ratio is 10 %. Money multiplier = 1/ reserve ratio

Money multiplier = 1/0.10 = 10

Total increase in money supply = 1000*10

= $ 10000

After all steps are completed , Reserve will increase to $ 1000 which is 10 % of $ 10000 , total money M1 will increase by $ 9000

If reserve ratio is 20 % , multiplier = 1/0.20

= 5

If the banks will be holding more excess reserves , their lending power will decrease and hence the money multiplier will drop and there will be lesser increase in money supply.

The process of money creation will be as follows -

Initial deposit = 1000

Reserve ratio = 10 %

Total money created = $ 9000

Total reserves = $ 1000