Money Multiplier Formula, Concept UPSC Economy Notes

The table showcases the values of the money multiplier under various situations, such as changes in fiscal policy, exchange rate movements, and international trade. It also highlights the impact of capital accounts, foreign investment, and balance of payments on the money multiplier. It’s interesting to note that while banks have significant power in creating new money, ultimately, it’s regulated by the Reserve Bank of India. The central bank carefully monitors this process to prevent excessive creation of new deposit funds which can lead to inflationary pressures on an economy. Notably, Reserve Bank is responsible for ensuring stable growth conditions, balancing inflation levels through Monetary Policy Operations (MPOs). It influences bank lending activities and regulates financial activity while maintaining monetary stability in tandem with fiscal policy objectives.

1. However, this theory has been criticized on the ground that an increase in savings allows banks to lend more leading to increase in Investment and GDP growth.
2. Post Offices’ saving deposits (excluding National Saving Certificates) are part of M.
3. The effect of the money multiplier can be seen in commercial banks of the economy.

In the concept of the Money Multiplier, the number of multiples depends on the percentage of the legal reserve ratio. It focuses on the relationship between the money supply and the money stock in terms of high-powered money. The Money Multiplier is an important topic in Indian Economics and is asked frequently in the UPSC Exam. While discussing this topic, we will also get to learn about important concepts like legal reserve ratio, statutory liquidity ratio, and much more.

Money Multiplier – Indian Economy Notes

To excel in competitive exams such as UPSC, it is vital to understand both basics and advanced concepts such as money multipliers since they form part of current economic/discussion topics. Having detailed knowledge about these concepts would help aspirants gain a competitive edge over others while preparing them to ace such exams fearlessly and confidently. This means that the money the public hold in hand or in the bank is a debt guaranteed by the government (to us). The currency thus represents a ‘public debt’ owed by the government to the holders of the banknotes – the public.

Money Supply – In layman’s terms

The use of these measures curbs excessive credit creation and sensitive price changes that may occur as a consequence. But the demonetisation impact is neutralised when the demonetised currency is replaced with new accepted currency notes. You may note that, even if an individual chooses to park the cash as deposits with banks, it forms a part of the overall money supply. In the money supply statistics, central bank money is M0 while the commercial bank money is divided up into the M1 and M3 components.

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For different calculations, different components are included as ‘money’. The higher the rate of LRR, the lower will be the Money Multiplier and vice versa.

L1 – NM3 + All deposits with the post office savings banks (excluding National Savings Certificates). Essentially, the Keynesian multiplier is a theory that states the economy will flourish the more the government spends, and the net effect is greater than the exact dollar amount spent. Different types of economic multipliers can be used to help measure the exact impact that changes in investment have on the economy. The concept of Money Multiplier explains how many times a sum of deposits will be multiplied in the economy when it is spent and again re-deposited into the banks. In this article, we mainly concentrate on the new monetary aggregates.

M1 is most liquid & easiest for transactions whereas M4 is least liquid of all. L2 – L1 + +Term deposits with term lending institutions and refinancing institutions (FIs) + Term borrowing by FIs + Certificates of deposit issued by FIs. Monetary aggregates are the measures of the money supply in a country. First, economies experience direct impacts when an economic factor is directly attributed to an entity. For example, when a government awards a tax incentive to an individual, that individual is said to have received the direct financial impact. For example, assume a company makes a $100,000 investment of capital to expand its manufacturing facilities in order to produce more and sell more.

Economics

However, there are numerous reasons why the actual money multiplier is significantly lower than the theoretically possible money multiplier in the real world. Assume that the bank has received a deposit of Rs 1000 and the LRR is maintained at 20 percent. Now, the bank will keep Rs 200 as reserves (LRR) and the rest of the amount will be made available to the public in the form of loans. Now, a borrower takes a loan of Rs 800 from the bank either for consumption or for investment purposes. The bank never holds excess reserves and non-bank entities and individuals never hold currency. Total liability of RBI is called monetary base or high-powered money.

Furthermore, the Money Multiplier mechanism in India has a unique history, with multiple countries adopting different variants of it. The Reserve Bank of India, in particular, has played a vital role in implementing https://1investing.in/ this mechanism to enable the Indian economy’s growth and development. In addition to these mentioned factors, there may also be other unforeseen economic situations that would affect the Money Multiplier.

These factors can dampen the effect of an increase in money supply, undermining the usefulness of the multiplier in monetary policymaking. By using this formula, banks can calculate how much additional deposits they can create by using their existing reserves. The required reserve ratio is set by the Reserve Bank of India and represents the proportion of a bank’s deposits that they must hold as reserves. A money multiplier is a method of demonstrating the maximum amount of broad money that commercial banks could create for a given fixed amount of base money and reserve ratio.

The Multiplier Effect significantly assists in measuring the impact of changes in various economic activities such as investment or spending and what it will have on the total economic output. From 1977 to 1998, RBI used four monetary aggregates – M1, M2, M3 and M4 – to measure money supply. Similarly, a lower reserve ratio results in a higher money multiplier that allows a lesser amount of money to be kept as a reserve and more lending opportunities to the public. The multiplier effect is an economic term, referring to the proportional amount of increase, or decrease, in final income that results from an injection, or withdrawal, of capital. In effect, Multipliers effects measure the impact that a change in economic activity—like investment or spending—will have on the total economic output of something. Also, we will look at the Reserve Bank of India’s role in controlling the Money Multiplier.

It is a major liability component of a central bank’s balance sheet. The money supply is the total stock of money circulating in an economy. In the most simple language, Money Supply is Currency in Circulation plus Deposits in Commercial Banks. Money Multiplier is sometimes also referred to as the credit multiplier or the monetary multiplier. This happens because we have assumed that there is only a single bank in the economy. After receiving Rs 800 from the seller, the bank will again keep aside 20% of the amount i.e Rs 160 as reserves, and provide a loan to the public with the remaining amount.