The Formula for Money Multiplier Calculation

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  • The amount of money that the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more or the banking system will generate with each dollar reserve. That will depend on the reserve ratio.The bank’s more money to hold them in reserve, the less they would lend the loans. Thus, the multiplier maintains an inverse relationship with the reserve ratio.

Examples

Example #1

Calculate the money multiplier if the reserve ratio is 5.5% prevailing as per current conditions.

Solution:

Given,

Reserve Ratio = 5.5%

Therefore, the calculation of the money multiplier will be as follows: –

Money Multiplier will be –

=1/0.055

=  18.18

Hence, the money multiplier would be 18.18.

Example #2

World WWF was one of the most prosperous countries globally in handling the country’s financial and economic conditions due to Mr. Right, who led the Central Bank. Mr. Right retired a few years ago; then, he was succeeded by Mr. Medium, who is looking after the current affairs of the Central Bank. It observed that the country faces high inflation compared to a few years ago. The Central Bank is now interested in reducing inflation, and one way they have thought of it is by injecting liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more into the market.

Due to the peak of currency depreciationCurrency DepreciationCurrency depreciation is the fall in a country’s currency exchange value compared to other currencies in a floating rate system based on trade imports and exports. For example, an increase in demand for foreign products results in more imports, resulting in foreign currency investing, resulting in domestic currency depreciation.read more, the Central Bank is hesitant to print new currency. It is also not interested in lowering the bank rates as that might result in the outflow of FII funds. In the meeting held, where the former Governor of the Central Bank, Mr. Right, was also invited, he suggested reducing the reserve ratioReserve RatioThe reserve ratio is the minimum percentage of the amount defined by the central bank to park aside by every commercial bank. The Central Bank can change this ratio depending upon the economic environment. read more from 6% to 5%. The current money supply in the market is U.S. $35 trillion, and Mr. Right also suggested injecting the U.S. $1 trillion, which they already hold in reserves. After this action, the banks’ target money supply in the market is U.S. $54 trillion.

You must calculate the money multiplier and whether a Central Bank took action with suggestions from Mr. Right to be impactful. What will happen if the reserve ratio is not changed?

Money Multiplier will be:

= 1 / 0.05

=20 times

Hence, this would mean that if 1 unit of money is deposited in the economy, it shall multiply that money in the economy by 20 units.

Therefore, if the Central Bank aims to inject U.S. $1 trillion into the market, that would lead to a money supply of U.S. $1 trillion x 20 times, which equals U.S. $20 trillion. There is already a money supply of US$35 trillion; this U.S. $20 trillion would reach the U.S. $55 trillion economy in virtual terms. The action plan was the U.S. $54 trillion; per this ratio, there is a surplus of U.S. $1 trillion.

If the Central Bank kept a reserve ratio of 6%, the money multiplier would be 1/0.06, which is 16.67. If preserved, it would not reach the Central Bank’s target.

Example #3

Two students were arguing with each other on the topic of a money multiplier. The first student says if the reserve ratio is kept low, the more money supplies, the lower the inflation in the economy. At the same time, the second student stated that the higher the ratio, the less the money supply, which would reduce inflation. You must validate which statement is correct, taking 7% versus 8% as the reserve ratio.

We are given an example of the reserve ratio, and from this, we can calculate the money multiplier from the below formula: –

Case I

Reserve Ratio – 7%

= 1 / 0.07

=  14.29

Case II 

  • Reserve Ratio = 8%

=  1 / 0.08

 = 12.50

The above can infer that keeping a reserve ratio at 7% will infuse more money as it will be more circulated, whereas keeping it at 8% will infuse less.

Hence, if more money comes into the market, inflation will increase, and vice versa will be the case. Therefore, the statement made by student 2 is correct that a higher reserve ratio will reduce inflation, and the information produced by student 1 is incorrect.

Money Multiplier Calculator

You can use this money multiplier calculator.

Relevance and Uses

As with almost all countries for the banking system, commercial banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits.read more are only required to hold for all deposits as a certain percentage as reserves, which is termed the reserve ratio. The remaining deposits can be utilized to lend out the loans, increasing the money supply. However, one must note that the creation of money will not pause here. It will further deposit the newly created money in a different bank, lending a fraction to other customers. That will continue and can also repeat this process forever in theory.

This article is a guide to the Money Multiplier Formula. Here, we learn how to calculate the money multiplier using its formula, practical examples, and a downloadable excel template. You can learn more about economics from the following articles: –

  • Multiplier FormulaStackelberg ModelStackelberg ModelStackelberg model is a leadership strategy where the dominant firm decides the quantity of goods it will produce. Subsequently, the follower firms in the market ascertain their production quantity. A firm becomes a market leader based on its size, previous performance, innovation, reputation, etc.read moreHedonic PricingHedonic PricingThe Hedonic Pricing Model is a pricing model for goods sold that takes into account both internal and external factors. This model, developed by Sherwin Rosen in 1974, determines home prices based on internal and external factors in the housing industry.read more