How do we create money? What is government spending multiplier?

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Expert Solution

Most of the money in the economy is created by banks. Suppose an individual A deposits $100 in bank X. The reserve requirement is 10%. So banks will keep $10 as reserves and will lend rest $90 to individual B. Individual B will deposit this $90 in his bank say bank Y and will withdraw the money when needed. The deposits of bank Y increases by $90. Reserve requirement is 10%. Bank Y will thus lend $81 to individual C. Individual C will deposit $81 in his bank say bank Z. This process will go on. Thus the total money supply = $100 + $90 + $81 = $271. Thus with an initial deposit of $100, the money supply increases to $271 in an economy. This is how money is created.

Government spending multiplier refers to the increase in GDP when there is an increase in government spending. Here, the increase in GDP is greater than the increase in government spending. Thus, it is the ratio of change in income to change in government spending. In other words, an increase in government spending has a multiplier effect. This is because when government spending increases , it triggers the GDP to increase . Further ,the increase in income induces consumer's to increase their consumption expenditure. This again increases the national income. Thus, increase in government expenditure has a multiplier effect on national income.

Rahul Sunny answered 1 year ago

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