Money multiplier: definition and features

2024 Author: Howard Calhoun | [email protected]. Last modified: 2024-01-02 13:48

Issue of money in a developed system of market economy and banking system is subject to the effect of the money multiplier. In this case, situations may arise of an increase in the money supply compared to its initial emission.

The concept of the multiplier of the monetary system was first used by R. Cann at the beginning of the last century, and later this theory was developed by J. Keynes in his work on the general theory of employment, interest and money.

Cartoon principle

To describe the multiplication principle, let's introduce the terms of reserve and deposit rates.

The reserve ratio shows the ratio of reserve volumes to the share of deposits held in commercial banks:

rr=R/D where

rr - reserve rate.

D - deposits.

R - reserves.

Deposit rate shows the ratio of cash to deposits:

cr=C/D where

cr - deposit rate.

C - cash.

D - deposits.

Money multipliermass is a coefficient indicating how many times the amount of money will be reduced or increased if the money supply is reduced or increased by one unit. The multiplier can change both up and down. If the Bank of Russia plans to increase the amount of money, then it will increase the monetary base. Several mechanisms exist and are actively working to facilitate this process. With opposite plans, it is logical to expect a decrease in the amount of money. The money supply multiplier depends on current reserve and deposit rates. The larger they are, the larger the reserve volumes are kept unused by the main manager of funds - the Bank of Russia. The greater the share of cash that the population does not invest in deposits, the lower the value of the multiplier, which is not positive for the country's economy.

Deposit impact

Deposit rate is the ratio of cash to non-cash. When does the increase occur? Just when the amount of money in cash in the country will increase in relation to non-cash.

Money multiplier is:

m=(cr+1)/(cr+rr), where rr is the reserve rate and cr is the deposit rate.

The last indicator is present both in the numerator and in the denominator of the calculation formula. It affects the money multiplier in the following way. If the value of the deposit rate approaches one, then the value of the multiplier will be less dependent on the rate of mandatoryreserves. Theoretically, it is possible that the deposit rate will be more than one, that is, there will be more cash in the country than non-cash funds.

Calculation formula

You can derive the mathematical formula of the money multiplier coefficient from two mathematical expressions in stages:

• Let's look at two formulas rr=R / D and cr=C / D, where C is cash, D is deposits, R is reserves.
• Taking the above two formulas, we get the equalities: H=C + R=cr x D + rr x D=(cr + rr) x D and M=C + D=cr x D + D=(cr + 1) x D.
• The first equality is divided by another: M / H=((cr + 1) x D (cr + 1)) / (cr + rr) x D (cr + rr)=(cr + 1) / (cr + rr).
• We get equality: M=((cr + 1) / (cr + rr)) x H, hence: M=mult_{money x H.}
• Money multiplier equals mult_money=(cr + 1) / (cr + rr). In this formula, mult_{cashis the multiplier, rr is the reserve rate, cr is the deposit rate.}

Assuming that cash does not exist, the ratio will be calculated using the formula mult_{bank=1 / rr and called the money bank multiplier.}

Dependence of the multiplier and the mass of money

The multiplier is always used to regulate the money supply. The main bank adjusts the ratio by changing the volume of banks' reserves in the country's main credit institution.

Money supply multiplier in some advanced countrieseconomic system can exceed twice the initial amount of money issued. In the process of regulating the value of the multiplier (k) by the Bank of Russia, the term monetary base arises. Its foundation is based on the concept of cash (M_{0) as a liquid means of payment and obligatory deposits of corporate banks in the main credit institution of the country.}

The monetary base equals the sum of:

• Cash.
• Money in the required reserves and in the accounts of commercial credit structures in the Central Bank of the country.

The monetary base shows how much money can be used by the Central Bank of Russia. It is calculated by the formula:

Money supply (M_{2)=Monetary baseMoney multiplier.}

The higher the required reserve ratio of funds by commercial banks in the Central Bank, the lower the multiplier coefficient. The money multiplier formula shows its dependence on the required reserve ratio. If the multiplier rises, then there is an increase in the non-cash amount of money compared to cash, since the change in the multiplier always depends on the increase in cash money and the balance of correspondent accounts.

Bank cartoon

The issue of money is carried out differently in countries with command and market economies. In the first mode, money is issued based on directives from above. In a market economy, there is a banking system consisting of twolevels - in the form of the country's main bank and commercial banks. Here, the issuance mechanism is based on the influence of the money multiplier in the banking system.

Banking multiplication functions only within the framework of a multi-level system:

• The Bank of Russia manages this system.
• Commercial banks make it work automatically, regardless of the goals of the heads of individual banks.

Main tasks of the Central Bank of Russia:

• Stablely secure the country's currency.
• Establish a credit and monetary policy.
• Promote bank control.

Main functions of the Central Bank:

• Issue national currency.
• Lender to all banks.
• Be the main cashier for all payments.
• Ensure control over all credit institutions.

The policy of the main credit institution of the country is a set of measures in the field of the monetary system. The main goal of the policy is to create conditions for achieving sustainable growth in the level of production, price stability, a high level of welfare for the population and the balance of the country's activities in the foreign market.

As part of the policy of the main creditor of the country, methods of regulating the monetary sphere are used: direct and indirect. Direct methods are administrative in the form of various orders of the Bank of Russia. These methods are fast and efficient. The controlling function of the Bank of Russia for the price orthe maximum amount of placed and issued funds, especially in the context of the financial crisis, fully justifies itself. However, direct methods of influence in case of a negative impact on their work can cause the export of finance from the country abroad.

Indirect methods of regulation of the monetary sphere have an impact on the behavior of business entities through the mechanisms of a market economy. The effect of using indirect management methods of the Bank of Russia is closely related to the stage of development of the economy of our country. During transitional periods, both direct and indirect instruments are used with the gradual capture of the first instruments by the second.

Basic methods are indirect in numerical advantage. They affect the money market as a whole. Combined methods govern specific types of lending and are command-and-control from above. For example, a direct limitation on the size of loans issued by banks for consumer needs, limiting the maximum limits of loans per borrower.

There are two types of state monetary policy in the economy: expensive money and cheap money. This or that policy is built by combining the main tools used by the main regulators.

The policy of cheap money is typical for a situation of recession in economic development and high unemployment. Its purpose is to make loans cheaper and more readily available to increase the money supply. This entails an increase in total costs and investment in production. The following measures apply:

• Lower interest rates to encourage more borrowing from the main regulator and expansion of own reserves from commercial institutions.
• The purchase by the main regulator of securities of value, paid for by an increase in bank reserves.
• Reduction of the reserve ratio by the main regulator, bringing the required reserves into the required ratios.

The dear money theory aims to reduce the supply of money in order to reduce total spending and reduce inflationary rates. It includes the following activities:

• Raising the discount rate, limiting commercial bank borrowing from the main regulator.
• Sale of government-issued securities by a central creditor;
• To reduce excess reserves, increase the required reserve ratio;
• Decrease in the money supply multiplier.

One credit institution cannot multiply funds, as they are increased or decreased by a system of interconnected credit institutions. In the event of a decrease in the required reserve ratio, the money multiplier is triggered, the free reserve of banks increases, leading to an inevitable increase in the volume of borrowing and the activation of the multiplication mechanism in the sector of the country's credit institutions.

Of all the active investments of commercial credit institutions in operating processes, only borrowed investments create new objects of placement of funds, that is, they allow performing the issuing function of banking institutions.sectors. The larger the share of loans in its assets, the larger the volume of its money issuance activity.

Since the banking multiplier is formed on the operations of commercial banks to place and attract money, it is often called the monetary multiplier in the literature on economics and finance. This is a ratio that describes the reduction or increase in reserves held in the financial sector. It is formed as a result of the emergence of new cash deposits. They are born at the moment when loans are issued to clients of banking institutions from free reserves that arrived at a credit institution from outside.

Borrowed resources that left one commercial bank in the form of issued loans become the property of another banking institution, which, in turn, gives these non-cash funds to its customers. A currency issued by one bank creates credit reserves for another bank in its balance sheet.

Credit multiplier

The bank multiplier describes the process of increasing or decreasing money from the point of view of the subject. It answers the question of who raises the money.

The credit multiplier answers the question of who is driving the increase. The process of expanding the volume of funds can be carried out when lending to any activity. The multiplier in the process of lending is the ratio of the process of increasing the amount of borrowing made by a group of commercial banks that causedchange in the volume of lending, to the process of increasing assets held in reserve. In other words, the multiplier in the credit sector shows the ratio of the change in deposit liabilities of commercial banks caused by the expansion of lending to the initial increase in assets held in reserve.

Deposit multiplier

This coefficient in the process of attracting funds reflects the object of increase, that is, the funds in the settlement accounts of credit institutions where deposits are placed, increasing in the process of multiplication. The main bank of the country, operating the multiplier mechanism, expands or reduces the emission plans of credit structures.

In the financial sector, the multiplier is the coefficient of change in the total output per one monetary unit of the increase in total demand. The multiplication of the money supply is understood as the process of issuing means of payment by participants in economic activities with an increase in the monetary base by one monetary unit of bank money.

The multiplier is a coefficient showing how much the supply of money will increase or decrease as a result of an increase or decrease in their placement in the money circulation system. The ratio of the money supply to the monetary base shows the money multiplier.

The monetary base in a simple sense includes money in cash and the required reserves of banks for funds raised in the country's currency in the Bank of Russia.

In a broader sense, the monetary base includes:

• Cash money.
• Required reserves.
• Bank funds on correspondent accounts with the Central Bank of Russia.
• Obligations of credit institutions to buy back securities of value and bonds of the Bank of Russia.
• Funds for creating reserves for operations in foreign currency deposited with the Bank of Russia.

The multiplier coefficient of the monetary system can be represented as:

• The ratio of money in cash to the total deposit volume in the banking system.
• Reserve rates, according to the established standard of bank funds, in the main credit institution of our country.
• Ratio of bank reserves to total deposit volume in the banking system.

Reservation rates

The ability of a commercial bank to create reserves is limited by the function of creating reserves with the operation of a set rate mechanism. Their volumes are determined by the reserve norm, the rules of which are determined by the administrative documents of the Central Bank. The Bank of Russia calculates reserve allocations as a percentage of bank deposits. Reserve allocations help the country's banking system to provide liquidity in difficult financial time periods and regulate the mass of money in external circulation:

M=1/Rn, where M is the money supply, Рн is the required reserve ratio.

To calculate the money supply that can be created by one unit of free reserves at a given reserve rate, calculate the money multiplier:

MM=(M₀ + D)/(M_{0 + R), where}

MM - multiplier in a certain period of time.

M_{0 - money supply outside the circulation of money in commercial banks.}

D - the amount of deposits held in the accounts of credit institutions.

P - reserves held on correspondent accounts and at the cash desks of commercial banks.

The multiplier can cause inflationary or deflationary processes. A stable, stable financial equilibrium in the money circulation market can change the money multiplier, which has increased or decreased over a certain period of time.

Factors of influence on animation

The size of the monetary multiplier directly depends on the following factors:

• Regulations on standardized reserves deposited by commercial lending institutions.
• Decrease or increase among residents of the country and business owners in demand for loans and an increase in the percentage of borrowing funds at the same time, as a rule, entailing a decrease in the provision of loans, a decrease in the volume of funds accepted for placement.
• The use by individuals of funds borrowed from banks for cash transactions, which causes the suspension of the multiplication and reduces its real value.
• Increase in cash receipts to accounts of private and corporate clients or sale of assets in the market of operations between banks, which creates conditions for an increase in the bank multiplier.

Results

The modern financial world is arranged in such a way that cash means of payment occupy a small part of the total money supply. To a greater extent, at this stage of economic development, citizens use cashless payments. The main part of the monetary volume is formed by commercial banks due to the operating activities of credit institutions (placement of deposits, issuance of loans and borrowings). It is not easy for an ordinary layman to immediately understand the mechanism of increasing or reducing money in the economy.

Let's summarize and recall the main points described in the article above:

• To change the level of the money supply, a mechanism is used in the form of a reserve ratio of the established norm and interest on funds raised, which commercial banks are required to transfer to a correspondent account with the Bank of Russia.
• The money supply is larger in volume than the amount of the initial issue of cash or the monetary base. The ratio of the money supply to the monetary base shows the value of the money multiplier.
• The mechanism of the bank multiplier is manifested in the case of issuing loans to commercial banks, buying securities of value from them, or foreign currency. When the multiplication mechanism is activated, the resources of commercial credit institutions invested in active operations decrease in the banking sector, and the free reserves of these organizations used for active operations increase.
• The Bank of Russia can turn on the multiplication mechanism when it reduces the reserve deduction ratio and increases the free reserve of credit institutions. This situation leads to an increase in loans provided in the real sector of the economy and to the inclusion of the bank multiplier.
• The main bank of the country, acting as the main regulator, performs its task of managing the monetary system by expanding or contracting the volume of bank money. The money multiplier demonstrates the process of repeatedly increasing or decreasing money as deposits in commercial banks. This occurs in the process of increasing or decreasing banks' reserves when commercial financial institutions carry out operations to attract and place funds within the existing system.
• Multiplicative can be both an increase and a decrease in the money supply. Analysts of the financial sector pay most attention to the moments of repeated multiplication of money, because the reliability and stability of the monetary system of our country and the falling or rising inflation rate depend on this.