The Mechanism of the Money Multiplier - Report Example

?THE MECHANISM OF THE MONEY MULTIPLIER Introduction This paper will aim to provide an explanation and illustration of the essential mechanisms behind the concept of money multiplier and intensively the manner monetary authorities can control its size and influence money supply in the economy. First, an overview of money measure will be put forth. Secondly, the mechanism in light of money multiplier will then be explained by use of symbols and equations to elaborate the cyclical variations in the multiplier factor. This will be followed by a scrutiny of money multiplier in the present economic environment which will be explained and lastly a description of the instruments of controlling money supply such as open market operation, reserve ratio and the discount window will be put in details to explain the impact in the size of money supply. A conclusion will then be provided of the general overview of the essay. The Reserve Ratio According to Valdez & Molyneux (2010, p. 111), different measures or dimensions can resolve on the issue of money supply denoted as M via monetary aggregates such as M2 and M4. The monetary aggregate M1 equals to the cash held household whilst M2 refers to the sum of deposit within the bound of retail banks and building societies in addition to the cash held by the household. M4 gives a broader measure of money which comprise of wholesale bank deposits and certificate deposits. These can be expressed as; M1 = Cash held by households M2 = M1 + retail banks and building society’s deposits M4 = M2 + wholesale banks deposits + certificate deposit The measures of money explained above shows the liquidity level of money held in supply even though broader measures indicate less liquidity held. The correlation amidst the bank of England, commercial banks and the households and the behavior which describes the supply of money in the form of deposit ratio of the currency and the reserve ratio. This can be expressed as; M = Deposits (D) + Currency deposit ratio (CU). The money multiplier maintains the mathematical connection amidst the monetary base and the economic supply of money. The monetary base or the high powered money is the summation of the currency in supply in addition to the banking system’s reserves. The money Multiplier can be articulated as; 1/rr this is the inverse of the reserve requirement ratio. For example if the reserve requirement is 20% then the multiplier effect is equal to 5. The extension of a nation’s Money supply that comes from banks ability to lend, the extent of the multiplier effect relies on the fraction of deposits that the banks are stipulated to maintain as reserves. In other terms, it is money used to make more money and is established as division of the total Bank deposits by the requirement of the reserve. The effect of the multiplier is dependent on the reserve requirement that has been set. Thus to get the effect of the multiplier on the supply of money, the first step is to get the amount banks earlier on take in via the deposits and then divided it by ratio of the reserve. For example, in case the reserve requirement is about 20% for each ? 200 a customer makes deposits into a bank, then ? 40 must be maintained as reserve. Nonetheless, the remaining ? 160 can be advanced to other banks customers as loans. This ? 160 is then made as deposits by the customers into other banks which simultaneously also keeps 20% or ? 32 in reserve but can loan out the remaining ? 128. This cycle goes on as more customers’ makes deposits of money and more banks proceed with the lending process until the ? 200 earlier deposited makes a total of ? 1000 (?200/0.2) in deposits. These deposits created forms the multiplier effect. It must be noted that the higher the reserve requirement, the tighter the supply of money, which eventually lead to a lower multiplier effect for every pound deposited (Cecchetti, 2008, p. 47). Subsequently, the lower the effect of the multiplier, the greater the supply of money which implies more money is in circulation. This is being established for every pound that is deposited (Ball, 2012, p. 13). The purpose of the reserves and the money in circulation in macroeconomic theory has a huge background. Open Market Operation and the Multiplier Effect An open market operation helps increase the reserves in the bank which also increases the monetary base. The rise in the monetary base is equivalent to the quantity of the open market operation and initially, it is also equivalent to the rise in the reserves at the bank. In case the federal bank or the central bank purchases securities from the commercial banks, the amount of deposits (and the amount of the money) does not vary (Ritter, Silber & Udell, 2009, p. 83). In case the central bank purchases securities from the public, the quantity of money or deposits rises by a similar quantity as the rise in the reserves by the bank. In either method the banks have extra reserves that they essentially begin to loan out. Notably there are various subsequent events that normally take place (Pilbeam, 2010, p.57). These includes, an Open market buy establishes an extra reserve, commercial banks loan out the extra reserves, the Amount of money in supply goes high, new money is used to make payments, part of the new money in supply is used as currency or currency drain, part of the new money in supply is maintained as deposits in banks, the banks stipulated reserves goes high and the extra reserves reduce but remains on the positive side. For example, in case the central bank stipulates that banks with ? 100,000 of extra reserves in an open market operation, the banks must then loan out those reserves. Part of the money loaned say ? 33,333 which represents 33% exit the banks in a currency drain and the remaining ? 66,667 is kept as deposits. With the excess deposits, the required reserves will go up by ? 6,667 which is about 10% of the reserve ratio and the banks can then lend as ? 60,000 as loans to the public. A section of this amount, ? 20,000 exits the banks in form of currency drain and ? 40,000 is maintained as deposits. This series of events goes on repetitively till the banks have established adequate deposits to do away with their additional reserves. An extra ? 100,000 of reserves might end up creating ? 250,000 of the money in supply. Discount Window and the Multiplier Effect When making money out of the discount window a bank is required to have new reserves to support the lending process and investment which has been made already or it is expecting to make. Thus is essentially seeks loans from other banks at the rate offered by federal funds rate. However, during the time of crisis which is replicated by the insufficient liquidity in the various banks, the entire system of banking requires an extra reserve which necessitates the central or the federal bank to allow for discount window. at the time a bank seeks loans overnight from the central bank’s discount window (which is at an interest rate set by the central bank actually known as the discount rate), the reserve account by the bank kept at the central bank is credited with the amount of the loan (and the central bank tops up to its existing assets the extra amount owed to it by the bank that asked for the loan) (Hubbard, 2002, p. 131). Given the bank borrowing acquires extra reserves and there is no other bank that loses its reserves, the resultant extra reserves that have been established for the system of banking as a whole. In case the quantity is about ? 100,000, the system of banking as entirety has an extra capacity to increase the loans and make deposits as much as ? 1 million. Therefore, the Central banks open market buys and the discount window lending have a similar final effect on the supply of money, at least till the discount window lending are repaid back (Howells & Bain, 2008, p.97). Conclusion In conclusion the treatment of the money multiplier effect provides the amount of bank reserves a causal role in establishing the amount of money and the lending by the bank which eventually lead to the transmission mechanism of the monetary policy. This duty emanates from the presumptions that reserve requirements results from an immediate and tight connection amidst the reserves and money and that the fed manages the supply of money by controlling the amount of reserves via the open market operations. If the data from the latest decades are to go by then this has been demonstrated that these explanations can be accepted for the rich facts and examples used. As noted from the discussion M4 fits to be among the best definition of the measures of money. It is a broader measure of money while M2 has only a smaller percentage of it in the reserves and hence only a smaller percentage is connected to the rank of the reserves balances the central bank or the fed via the open market operations. Bibliography Ball, L.M 2012, Money, Banking, and Financial Markets, Second Edition, Worth Publishers, New York. Cecchetti, S 2008, Money, Banking and Financial Markets, Second Edition, McGraw-Hill, New York Howells, P and K. Bain, K 2008, The Economics of Money, Banking and Finance: A European Text, Fourth Edition, Person Education limited, Harlow. Hubbard, R.G 2002, Money, the Financial System and the Economy, Addison-Wesley. Miskin, F.S 2010, The Economics of Money, Banking, and Financial Markets, 9th Edition, Addison-Wesley. Pilbeam, K 2010, Finance and Financial Markets, Second Edition, Palgrave Macmillan, Basingstoke. Ritter, L.S., Silber, W.L. and Udell, G.F. (2009) Principles of Money, Banking and Financial Markets, Twelfth Edition, Addison-Wesley, London Valdez, S. And Molyneux, P. (2010) Global Financial Markets, Sixth Edition, Palgrave Macmillan, Basingstoke Read More