Question

What determines the value of the money multiplier?

Answer 1

The value of the money multiplier is primarily determined by the ratio of Money Supply (M) to High-Powered Money (H).

i.e., `M_M = M/H`

Where M_M is the money multiplier

M represents stock of money.

H represents high-powered money.

The value of the money multiplier is always greater than 1.

The value of the money multiplier can be derived as follows:-

We know that M = C + DD = (1 + cdr) DD.

Where,

M = Money supply

C = Currency held by people

cdr = Currency deposit ratio

DD = Demand deposits

Let treasury deposits of government be D.

We know, High powered money = Currency + Reserve money

Or, H = C + R

= cdr D + rdr D

= D (cdr + rdr)    ... (Taking D common)

Money Multiplier `= M/H`

So, the ratio of money supply to high-powered money `M/H` becomes

`M/H = (1+cdr)/(cdr+rdr)`

But rdr < 1

So, `M/H = (1+cdr)/(cdr+rdr)>1`

The currency deposit ratio (cdr) and the reserve deposit ratio (rdr) play an important role in determining the money multiplier.

The currency deposit ratio (cdr) is the ratio of the money (currency) held by public to that they hold in bank deposits.

That is, `cdr = C/(DD)`

The reserve deposit ratio (rdr) is the proportion of the total deposits kept by the commercial banks as reserve.