Money Multiplier: Meaning, Applications & Significance - UPSC Notes

The term "money multiplier" is used to describe the banking and economics phenomenon whereby an initial deposit in a financial institution can create a much larger increase in the total money supply within the economy. This process occurs because the banking system can lend out some of the deposits and retain a fraction as reserves, which creates a multiplier effect in the process where those loans will be redeposited and re-lent multiple times. Money multiplier is the first important step in clarifying how money supply and liquidity with stimulation dynamics function.

This is a very relevant topic to General Studies Paper III under the Economy section of the UPSC Civil Services Examination. It lays down the foundational understanding of concepts such as monetary policy, banking operations, and stability in economics, making it essential for students who want to score in both prelims and mains examinations.

What is Money Multiplier?

The money multiplier effect proves how banking systems multiply some initial sum of money through the operation of lending. When a bank gets a deposit, it is expected to keep a fraction of it in reserve (as required by the reserve ratio) and lend out the remainder. The money lent is often redeposited in that same or another bank so that it can lend some fraction of those new deposits. This process keeps iterating, and thus, results in a multiplier effect on increasing the total money supply coming from the initial deposit. It basically explains the means through which the banking system can create money beyond simply the physical currency issued through the central bank.

To better understand this, imagine an example in which the reserve ratio is 10%. Suppose a person puts INR 1,000 in Bank A. Then Bank A has to keep INR 100 as reserve and can lend out INR 900. Then the INR 900, which is lent by Bank A, might be deposited into Bank B. Now, Bank B will have to keep 10% of INR 900, that is, INR 90, as reserve and will lend out the remaining INR 810. Similarly, every subsequent bank will have to keep 10% of the deposited amount as its reserve and will lend out the remaining. This initial deposit of INR 1,000 creates a much higher amount of money in the whole economy.

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Money Multiplier Formula

The money multiplier can be written mathematically in terms of the reserve ratio R. It is the percentage of deposits that the banks are required to maintain in the reserve. The formula is:

where, ( R ) is the reserve ratio. If the reserve ratio is 10% (0.10), the money multiplier would be:

[ M = {1} / {0.10} = 10 ]

This means that an initial deposit can potentially increase the total money supply by 10 times, illustrating the power of the money multiplier effect.

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Real World Applications of Money Multiplier

The money multiplier concept happens to be very extensively applied in most of the economic policies and strategizing. Central banks apply the reserve ratios to attain control over money supply and inflation and the general direction of the economy aside from other monetary policy measures.

• Monetary Policy: The reserve requirement is altered to alter the sum of money that banks may produce. The money multiplier increases whenever the reserve ratio decreases, thus increasing money supply. A positive increase in the reserve ratio reduces the money multiplier, contracting money supply.
• Quantitative easing: This is a policy through which the central banks buy government securities or other financial assets to infuse liquidity in the economy. In this manner, increased reserve in the banking system multiplies through the money multiplier effect, thus helping in recovering the economy from downturns.
• Credit Generation: Banks' money multiplier ability is essentially the very key to economic growth. As money lent by banks both to firms and consumers, investment and consumption start to pick up, thus enhancing overall economic activity.
• Financial Stability: The concept of money multiplier is central in determining the propensity for financial instability. Over-lending by the banks and excessive leverage lead to the creation of financial bubbles and crises.

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Significance of Money Multiplier

The money multiplier is important for several reasons:

• Economic Growth: It allows the expansion of the money supply, which can boost economic growth through funding investments and consumption.
• Inflation Control: Central banks can control inflation by managing the money supply through the money multiplier. Too much money creation causes inflation, while too little causes deflation.
• Policy Making: The term is used by economists and policy makers to explain and forecast the implications of a variety of monetary policies. It aids in framing an appropriate economic policy.
• Performance of the Banking Sector: It explains how bank lending can be an influence variable on the macro economy. An efficient banking function is necessary for an efficient macro economy.
• Crisis Management/Crisis Planning: In the times of monetary crisis proper forecasting of money multiplier helps in designing suitable policies to stabilize the macro economy.

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Conclusion

Money multiplier is an important concept in economics that explains how the initial deposits into banks can multiply many times increment in total money supply. This, therefore, makes it crucial for monetary policy, regulation of banks, and general management of the economy; thus, it's one of the most crucial subjects to study for any UPSC aspirant. By understanding its mechanics, applications in real life, and importance, candidates gain enough knowledge to analyze the given economic scenario and effects of policy decisions in entirety.

We hope that after going through the above article, all your doubts about the topic must have been cleared. Testbook provides quality preparation material for various competitive exams. Download the Testbook App here to ace your UPSC IAS exam preparations!