What is money multiplier? What determines the value of this multiplier?
Money Multiplier is the ratio of the total money supply created by banks to the initial reserves. It shows how many times the initial deposit multiplies through the process of credit creation by commercial banks.
The formula for Money Multiplier is: Money Multiplier = 1/Cash Reserve Ratio (CRR)
The value of this multiplier is determined by the Cash Reserve Ratio (CRR), which is the percentage of deposits that banks must keep as reserves. The CRR is decided by the Central Bank (RBI). For example, if CRR is 20%, the money multiplier will be 1/0.2 = 5. This means reserves of Rs 100 can create deposits of Rs 500. A higher CRR leads to a lower money multiplier, while a lower CRR leads to a higher money multiplier.
Explanation
The textbook explains that money multiplier is inversely related to the Cash Reserve Ratio. When CRR is 20%, reserves of Rs 100 can support deposits of Rs 500 (multiplier of 5). The RBI determines the reserve ratio, and changes in this ratio affect the lending capacity of banks, thereby impacting the money supply. If RBI increases CRR to 25%, the multiplier falls and banks must reduce lending.