High Powered Money Multiplier to Credit Creation - Essay Example

Macro and micro economic assignment By High powered money multiplier to credit creation. High powered money is considered the sum of the currency and commercial bank reserves that is held by the public. High powered money is the foundation for the banks deposit’s expansion and development of the supply of money. The supply of money varies inversely with the reserve ratios and currency and directly with the variation in the monetary base. High powered money consists of the assets that support multiplier expansion of money (DeFrancisci, 2008). The formula below is used to calculate the money multiplier. M= m + MB Where m represents the money multiplier, M is the money supplied while MB is the monetary value. The high power money multiplier is based on some assumptions, partial fulfillment and non fulfillment which impact on income generations. Some of the assumptions include; the supply of goods should be adequate, level of investment should be maintained, the economy should be closed and unchanged marginal propensity to consume. The advantages of high powered money multiplier High power multiplier has both advantages and limitations to the economy. When money is deposited into the bank by clients, the money is usually given out to other people in need of loans. The bank ends up getting interests in return. The rule associated with banking usually allows them to set aside some money referred to as reserve. The capital set aside by the bank is important in ensuring the daily cash needs of the bank are met (Steindl, 2010). It also ensures the depositors who come back to the bank to withdraw their money are accounted for. Such kind of banking is known as fractional reserve banking. Due to the reason of loaning out that the depositors’ funds by the company, a money multiplier effect usually result. To an individual the benefits are also withstanding. Through money multiplier an individual is able to acquire a loan from the bank for the purpose of expanding his business. The bank also offers protection and security to the deposited money. The high power money multiplier can aid in capital leverage. It ensures for example, the bank is able to make a lot of money out of the little money spent at the start. The individuals too are able to benefit (Bomhoff, 2008). If 10% is the reserve requirement, a bank may lend out $90 of $100 deposited by the customer. The $ 90 can also be lent to someone else who deposits the same amount to the next bank. The bank in receivership can lend out $81 dollars of the amount deposited. The initial deposit of $100 can be expanded through the banking system as the process proceeds. The amount can be expanded to a thousand dollars ($100+ $72.90+ $90+……. = $ 1000). Limitation of high powered money multiplier High power multiplier has limitations too, the system is sometimes risk and getting to know the disadvantages of the system will ensure the people and the banking systems are able to handle the situation. One of the problems that affect the system is when the depositors withdraw money from their accounts. The system is usually built on leverage, one dollar contributing to a lot of dollars. The multiplier effect can get money out of the economy as fast as it was created (Beenstock, 2007). For example if a depositor goes to withdraw money from a bank with a reserve rate of 10%.and withdraws 100 dollars in the event, the economy will lose almost a thousand dollars in capital. The effect will result to calling in of a thousand dollars in loans. The economy will end up losing the utility of the money in context. The limitation of high power money multiplier occurs when people misuse the money borrowed through making bad loans with the money deposited. If the bank fails to recover the 90 dollars from the a hundred dollars borrowed then close to 1000 dollars will be leaving the economy. Bank fraud is another disadvantage of the system. In order to determine the supply of money, the following formula can be applied; M = Cp + D p (M = money supply, Cp = Cash available and Dp represent the deposits in the bank). The formula shows that money supply involves both the money in circulation and the amount deposited by the people in the banks. Without the bank putting in place proper oversight, excess money may be lent out leaving less amount of money as reserve. If the reserve capital is less to promote the operation of the company then bank fraud occurs. Another limitation to high power multiplier is a deflationary economy. Deflation impacts negatively on the economy due to reduction of property values (Carpenter & Demiral, 2007). The ability of the people to maintain their loan usually reduce when the value of the property decline. The situation should slows or reduce the money supply chain. As the banks call in the loans, the supply of money decline and the down turn is accelerated. The main component of the money multiplier can pose a risk to the banking system. A run targeting the banking system can be catastrophic but a run in the bank can be mitigated by banking system cooperation and deposit insurance. Economic manipulation is another problem limitation of high power money multiplier. It allows the state banking authority and the government treasury department to affect the capital system with small inputs that are relative. In countries such as the United States for example the treasury department can lent and borrow fund or deposit the fund in banks. Due to the money multiplier system, a hundred billion dollars loan can amount to a trillion dollars impact in the system of the United States. Alternative theories accounting for high powered money multiplier approach The money multiplier theory stipulates that the total commercial bank money supplied is usually the reserve amount times the money multiplier. The theory stipulates that in cases where the bank lacks excess reserves the total money supply is equivalent to money multiplier times the reserve time. The theory asserts that a central bank may be able to impact on the economy and the money supply be changing the requirements of the reserve (Carpenter & Demiralp, 2007). Money multiplier is the money supply relationship with the reserves. The formula is 1/r where r represents the reserve ratio. Commercial money is the money present in people’s accounts, in debit and credit cards. Central bank money is the amount of money generated by the central government. It is made up of physical currencies in the bank vaults or the bank reserves held in the central bank reserves. When Margie deposits one million dollars into a bank in the town of Ceelo, a money multiplier effect occurred. The single deposit led to a series of deposits and loans in the town which led to an increase in economy and money supply in the market. The single amount deposited gave rise to an increased supply of money in the economy. The fiscal multiplier effect happens when the initial money supplied into the economy results to a greater national income. The formula below can be utilized in calculating high powered money multiplier; M.S. = C + D H = C+ R M.S. = C+ D H C+ R M.S. = C/D+ D/D H C/D + RD M.S.= C/D + 1 H C/D + R/D M.S = C/D +1 * H C/D + R/D M.S. = h * H h= C/D + 1 C/D + R/D High power multiplier works under some assumptions, which include; R/D stable values that are relative, H being exogenous and C/D stable values. R/D is the ratio of the reserve of the bank to their liabilities. In cases where r/d is greater than one, h will be less than one. The situation occurs when the bank keep too much capital as reserve. C/D represents the amount of money held by the public. The formula implies that increase in the amount of money deposited in the bank will affect the money supply by increasing the amount of loan to be given out to the people. The banks are able to increase the loans to the other banks and in the process get more money. Real GDP Trend Peak Trough Contraction expansion Time The cycle compares GDP against time. It represents a period of contraction and expansion with the peak level in the money multiplier approach Flow of funds is utilized in monitoring the flow of money in various economic sectors. It analyses data which focuses on investment, borrowing and lending throughout sectors such as businesses, firms and households. The flow of fund is tracked by the central bank. The Federal Reserve Bank in the United States of America is tasked with analyzing and tracking the flow of fund. The flow of fund accounts is utilized as performance indicators. The flow of fund can be used in analyzing the economic financial strength of a certain country. The theory of Minsky is set within an expansive economic context. Optimism is raised as development increase. Speculation increases due to the rise of financial asset prices. Speculation in this context is perceived to be a bet on market psychology and future direction. Financial system becomes fragile due to changes in the liability structure and risk attitudes. As fragility level goes up liquidity declines and money supply is affected in the process. Convectional theory has been supported as the theory that explains creation of money. Commercial banks make money through bank deposits and generation of new loans. The bank does not give out bank notes to a person wanting mortgage to buy a house. It only credits their bank accounts and in the process money is created. The bank does not necessarily transfer money from other people account as many people may think. Money supply theory is the other macro economic theory that tends to influence the supply of money in an economy. The theory targets the amount of money in the hands of the people within the economy that is utilized in purchase of services, securities and services (Walters, 2010). According to convectional economic theory, in an economy with a single bank, money multiplier = 1/ reserve ration. If $M dollars are introduced into the market, then $10M will be achieved at a certain time. Calculating the change in high powered money is indicated below; H = DEF- GD+ ET + MMA. (DEF, is the budget deficit of the government, GD is the government debt net sales, MMA is the money market assistance while ET is the governments external transactions. Y r/d r/d a R/d b TIME When R is less than one then h is more than one. High growth rate is witnessed at the pick f the business. At a bank continues lending money and keep low reserves. GDP growth is thus reduced from a to b. FED affects the supply of money in the economy, in various ways. Money supply in the modern economy is determined by the government. The government usually injects money into circulation any time it purchases assets and goods from the private sector. The government takes out money by selling assert to individuals and institutions and also levying taxes on the private sector. The central bank is tasked with controlling the supply of money. It sells and purchase bonds from the private sector and in the process controls the supply of money. High powered money multiplier effect in some countries According to Mori (2011), it has been reported that the money multiplier is falling in some countries due to quantitative easing associated to lax of policies. The money multiplier in Europe and United States is greater than two in periods of high growth and increased interest rate. The reserve percentage in the United States is 10%, Unlike in Europe where it varies from one bank to the other. In the 2013 the money multiplier in the United States has been lower than one. This means that 1 dollar generated by the central bank results to even lower amount in the economy (Zaki, 2009). The phenomenon is due to qualitative easing by the BoE, BoJ and Fed banks. The monetary transmission failure targets countries such as U.K, U.S and other countries in the euro zone associated with a GDP of 40%. Both the United States of America and some countries in southern Europe and becoming competitive due to wages that keep on stagnating. Japan and euro zone are believed to be making progress out of recession. Studies also indicate that the United Kingdom and the United State’s central banks and policies have started doing well. The data indicate that the US and UK’s money multiplier is picking up and stabilizing. Despite the United States and United Kingdom recording improvement in the policy and banking systems, Worrying trends are being experienced in Japan and the euro zone. Japan has been hit hard since it is dealing credit issues that have been long-term. References Argy, V. 2008. Money Supply Theory And The Money Multiplier. Australian Economic Papers, 27-36. Bomhoff, E. 2008. Predicting the money multiplier. Journal of Monetary Economics, 325-345. Beenstock, M. 2007. The determinants of the money multiplier in the United Kingdom. Journal of Money, Credit and Banking, 464-480. Carpenter, S., & Demiralp, S. 2007. Money, reserves, and the transmission of monetary policy: Does the money multiplier exist? Journal of Macroeconomics, 59-75. DeFrancisci, L. J. 2008. Money as a Force Multiplier in COIN. Military Review, 88(3), 21. Ertfrk, K. 2009. The Notion of Disequilibrium, the Multiplier, and the Endogenous Supply of Money. Review of Radical Political Economics, 74-83. Mori, H. 2011. Land conversion at the urban fringe: a comparative study of Japan, Britain and the Netherlands. Urban Studies, 35(9), 1541-1558. Steindl, F. 2010. The Negative View Of The Negative Money Multiplier: Reply. The Journal of Finance, 1818-1821. Walters, A. 2010. The Demand for Money--the Dynamic Properties of the Multiplier. Journal of Political Economy, 293-293. Zaki, M. 2009. Forecasting the money multiplier and the control of money supply in Egypt. Journal of Development Studies, 97-111. Read More