Define money multiplier. what is the value of money multiplier in a system of 100% reserve...

Define money multiplier. what is the value of money multiplier in a system of 100% reserve banking? what is the value of money multiplier in a system of fractional reserve banking, if all money is held in the form of deposits? Why is the money multiplier higher under fractional banking than under 100% reserve banking?

Solutions

Expert Solution

(a) Money multiplier measures the number of times that aggregate money supply increases in the economy, from a given increase in deposits in commercial banks. It is the ratio of Deposits to Required reserves ratio (RR).

(b) In 100% reserves banking, RR = 1, therefore Money multiplier = Deposits / RR = Deposits / 1 = Deposits.

In this case, increase in aggregate money supply equals increase in deposits.

(c) If all money is held in form of deposits, every additional dollar of deposit is lent out as credit and Money multiplier equals infinity (since RR = 0).

(d) In general, under fractional banking system, 0 < RR < Infinity. Therefore, out of $1 of additional reserves, the commercial banks are required to set aside ($1 x RR) amount of money, and lend out $[1 - (1 x RR)] as credit. But under 100% reserves banking, RR = 100% = 1, and banks have to keep every additional dollar of deposits as reserves and cannot lend anything extra. Therefore money multiplier is higher under fractional banking system.

Rahul Sunny answered 1 year ago

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