What is a Money Multiplier - Essay Example

Money multiplier is an economic expression that refers to the mathematical relationship existing between money supply and the underlying monetary base. So it, fundamentally explains the rise in the magnitude of money in circulation, which is generated from the ability of a bank to lend out money out of the funds deposited in the bank. (businessdictionary.com, 2011) This is a study set out to vividly consider the issue of money multiplier. This issue will be looked at from various perspectives and these will include the relationship of a country’s monetary policy and the money multiplier that is there in that economy. To this, there will be answering of the study question, “What is a Money Multiplier?” An economic view will be maintained in this study. The money multiplier is also known as the deposit or the credit multiplier. From the simple point of view, the term multiplier means the magnitude by which money supply expands and this is usually bigger than the rise in the equivalent monetary base. Thus, if the multiplier stands at 20, then it follows that an increase of $1 in the underlying monetary base will lead to a $20 rise in the supply of money. (moneyterms.co.uk, 2011) Formally, this can be illustrated by the formula below; Money multiplier = Change in Money supply/ Change in Money base (Kennedy, 2000 p12) Money multipliers can be divided into several types. One of these multipliers is the deposit expansion multiplier. This type of multiplier measures by what magnitude money supply can be increased from the original deposit. Thus, the formula that shows how the deposit expansion multiplier works is as under; Deposit expansion multiplier = 1/ Reserve requirement Where; Reserve requirement is the set deposit reserve for all commercial banks by the equivalent central bank. Taking that the set reserve requirement is 10%, then it follows that the deposit expansion multiplier is Deposit expansion multiplier = 1/ 0.20 = 20 Therefore, to determine the maximum magnitude of money that can be created through the set reserve, one can use the formula presented below; Money supply expansion = deposit expansion multiplier* excess deposit reserves Thus, if the one applies the multiplier computed before, and taking that the excess reserves from the original deposit are $800. The potential money supply expansion (M1) is to be determined as follows: Money supply expansion = 20* $800 = $16,000 M1, which is the sum of the original deposit ($1,000) plus the $16,000 that has been created is, therefore, $17,000. Note that the formula presented is what is usually referred to as the simple money multiplier. (Morton and Goodman, 2003 p197) Under the deposit expansion multiplier there are various assumptions that have to be considered. This is to ensure that the explanations presented make sense. These are with the inclusion of the bank customer’s usage of cheques to pay each other as opposed to usage of cash, banks usually keep a particular deposits’ fraction to take care of the central bank’s reserve requirements and even when customers do not get their payments they do not get to draw any deposits from the bank. (Gwartney, 2008 pp270-272) There is a possibility, though, that despite the set reserve ratio, the money multiplier will turn out less than the set multiplier. There are several reasons that could explain this. These include Safety reserve ratio- By this expression it means the percentage of deposits that a bank may want to keep beyond the set statutory reserve ratio. There is a possibility of lending more money than the set amount- Just due to the set amount of funds set for lending; it does not necessarily result to full lending. In a state of recession, for instance; people are not in a position to borrow, but instead prefer saving what they have. Banks will end up having bigger reserve ratios than the point of profit maximisation. Currency drain ratio- By this it means the percentage of banknotes, which individuals keep in form of cash, as opposed to depositing them in banks. Therefore, it means that if consumers deposited their entire cash in various banks, the money multiplier would turn out bigger than the set multiplier. (Pettinger, 2007) In the case where customers keep some cash, rather than deposit all their money in the bank, and in addition banks keep the balances set by the central bank as well as cash for the various transaction above the reserve requirements. It gives one a complex money multiplier formula: (1 + c) / (e + c) Where; c = the portion of money which customers retain as cash, and e = the amount that banks keep besides the set reserves. (faculty-web.at.northwestern.edu, 2011) Note that the sizes of a money multiplier and the variance in the set reserve ratio have an inverse relationship. Therefore, if the central bank reduces the set reserve ratio, then the money supply levels and the money multiplier will rise. If the central bank raises the set reserve ratio, the money supplies and the money multiplier will also increase. Then, there are limitations associated with the money multiplier that is being applied by any economy. These are with the inclusion of; The central bank may control the money deposits, but the members of the public may keep some cash besides the money that they keep as deposits, There may be some time lags, and The magnitude of the money multiplier may change. (Tucker, 2010 p415) It is of great essence to note that the concept of money multiplier is always linked with the monetary policy of a given country. While a monetary authority makes decisions, it must pick on a monetary aggregate that puts into account the entire instruments used to implement a country’s monetary policy. Besides this, the authority has to ensure that the relationship between the money supply and the set monetary aggregate is good, (that is, the underlying money multiplier is both predictable and stable). Therefore, so long as the monetary base falls under the powers of the monetary authority, then the determining of factors behind the variance in the money multiplier are vital in the monetary policy’s implementation. (Gokbudak, 1995) However, as per wordpress.com website, it is not possible to retain a fixed money multiplier while making monetary policy decisions. This is as has been witnessed during the recent global recession and financial crisis. Thus, banks had a very huge incentive to ensure that excess reserves worked by lending these funds to the willing borrowers. (wordpress.com, 2011) Basically, a monetary policy is meant to impact on the money supply of a given economy and therefore, it is of great essence to note some things about an economy’s money multiplier. In the real world, it is not possible to have the whole money multiplier being implemented fully. By this, the study means that a money multiplier is likely to be considerably smaller than the formulas showed before. The reason behind this is that customers to a bank may borrow and not use the whole stake. That is, a borrower may decide to keep some of the borrowings from a bank in their pockets, which leads to a money leakage. This leakage reduces a money multiplier’s value. (Tucker, 2010 p666) Also, banks may decide to keep more money than the required reserve. This may reduce the set money multiplier as has been depicted by the formulas presented prior to this discussion in the study. Most are the cases where banks retain more than the set reserves, and thus this reduces the amount of money that can be in supply as per the implemented money supply by the monetary policy. (colorado.edu, 2010) Therefore, the main factor to note under the relationship between the monetary policy of a given country and the underlying money multiplier as follows: if the reserve balances are prospected to affect the economy, then it is very unlikely that the standard money multiplier can be used to explain this impact. Purchases of assets may create huge reserve volumes, which is a byproduct of these purchases. It is then expected that there will result an independent impact on the given economy’s financial market. (Carpenter and Demiralp, 2010) While concluding this study, it is vital to make a note that despite the fact that money multipliers are usually looked at from the perspective that it is just a simple deposit expansion multiplier, the case is not so. However, a simple deposit expansion multiplier is essential in explaining how a money multiplier works. As mhhe.com website puts it, there is a complex money multiplier, which is the most likely in most case scenarios due to various economies being complex. (mhhe.com, 2011) Also as noted from the study, it is very hard to separate an economy’s money multiplier and its equivalent monetary policy. However, for that set monetary policy, the underlying money multiplier has to be predictable and stable. This is while trying to give a vivid and comprehensive answer to the study question, “What is a Money Multiplier?” Reference list: businessdictionary.com. (2011). Money Multiplier. Retrieved 14 December 2011 http://www.businessdictionary.com/definition/money-multiplier.html Carpenter, Seth B. and Demiralp, Selva. (2010). Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist? Retrieved 15 December 2011 http://www.federalreserve.gov/pubs/feds/2010/201041/201041pap.pdf colorado.edu. (2011). The Banking System and the Money Multiplier. Retrieved 14 December 2011 http://www.colorado.edu/Economics/courses/econ2020/section10/section10- main.html faculty-web.at.northwestern.edu. (2011). Macroeconomics. Retrieved 14 December 2011 http://faculty-web.at.northwestern.edu/economics/gordon/Gordon_Answers11e_ch13.pdf Gokbudak, Nuran. (1995). Money Multiplier and Monetary Control. Retrieved 14 December 2011 http://www.tcmb.gov.tr/yeni/evds/teblig/95/9505.pdf Gwartney, James D. et al. (2008). Economics: Private and Public Choice. Edition 12, illustrated. Cengage Learning. pp270-272. Kennedy, Peter. (2000). Macroeconomic essentials: understanding economics in the news. Edition 2, illustrated, reprint. MIT Press. p12. mhhe.com. (2011). The Complex Money Multiplier. Retrieved 15 December 2011 http://www.mhhe.com/economics/mcconnell15e/graphics/mcconnell15eco/common/doth emath/complexmoneymultiplier.html moneyterms.co.uk. (2011). Money Multiplier. Retrieved 14 December 2011 http://moneyterms.co.uk/money-multiplier/ Morton, John S. and Goodman, Rae Jean B. (2003). Advanced placement economics: macroeconomics: student activities. Edition 3, illustrated. Council for Economic Educat. p197. Pettinger, Tejvan. (2007). Money Multiplier and Reserve Ratio in US. Retrieved 14 December 2011 http://www.economicshelp.org/blog/67/money/money-multiplier-and-reserve-ratio- in-us/ Tucker, Irvin B. (2010). Macroeconomics for Today. Edition 7. Cengage Learning. pp 415, 666. wordpress.com. (2011). Money, the Money Multiplier, and Monetary Theory. Retrieved 14 December 2011 http://everydayecon.wordpress.com/2011/06/07/does-the-quantity-of- money-matter/ Read More