What is Money Multiplier?

The money multiplier is a concept in economics that demonstrates the maximum amount of broad money that can be created by commercial banks for a given fixed amount of base money and reserve ratio. It is traditionally presented as a simple proportionality relation:

Money Multiplier = 1 / Reserve Ratio

Here's a step-by-step explanation:

1. The central bank of a country injects a certain amount of money into the economy. This is known as the base money or high-powered money.

2. Commercial banks keep a fraction of this money as reserves (required by law) and lend out the rest. This is known as the reserve ratio.

3. The money lent out by the banks is then deposited back into the banks, and the process repeats. Each time, the amount of money in the economy increases.

4. The money multiplier is the measure of the maximum amount of money that can be created in this way. It is the inverse of the reserve ratio. So, if the reserve ratio is 10%, the money multiplier is 10, meaning that for every $1 of base money, the banks can create up to$10 of broad money.

5. However, in reality, the money multiplier is often less than this theoretical maximum, due to factors such as cash leakage (people holding cash rather than depositing it in banks) and banks holding excess reserves.