MONEY MULTIPLIER,Money Multiplier process,Money Multiplier vs Money velocity

 

MONEY MULTIPLIER:

• The phenomenon in which reserve money (M0) got transformed to another form of money supply  ie M1,M2 and M3 is referred to as the money multiplier .
• Money Multiplier  is based on the fractional reserve banking system.
• The size of the multiplier depends on the percentage of deposits that banks are required to hold as reserves. 
• Money multiplier effect is most commonly seen in commercial banks since deposits are accepted by them and a part of deposits is being disbursed as loan after keeping part as reserves.
• Money Multiplier results in creation of liquidity in the economy .

• Money Multiplier is inversely proportional to the Reserves 
• Money Multiplier is directly proportional to the Liquidity in the economy.
• When the reserve requirement decreases, the money multiplier increases, increasing the liquidity in the economy.
• When the reserve requirement increases, the money multiplier decreases, decreasing the liquidity in the economy.
• Lower Cdr-----------------------------------More demand deposits available to bank------------------more credit creation in economy -------------------Higher Money Multiplier .
• Lower Rdr ----------------less reserves with RBI –More money available to Bank ----Higher Money Multiplier 

FACTORS AFFECTING MONEY MULTIPLIER :

• Banking habits 
• Financial inclusion 
• Nature of loans

UNDERSTANDING THE MONEY MULTIPLIER THROUGH FIGURES :

The money multiplier – the ratio of M3 and M0 – has broadly remained stable at an average of 5.1 over April – December 2022 period compared to 5.2 in the corresponding period of the previous year. It has been in the range of 5.46 in feb 2024.

MONEY Supply and Money Multiplier process:

RBI issues /creates certain amount of money ie M---------------------Customer deposited this cheque of Rs M in bank A :

M-----------------M deposited in bank A  as demand deposit.

• Bank A------------Reserve M*.2 and M*.8-------Given to firms and Households as Loans and this M*.8 deposited to bank B.
• Bank B------------Reserve M*.8*.2----------------- M*.8*.8--------------Given to firms and Households as Loans and this M*.8*.8 deposited to bank C.
• Bank C-----------M*.8*.8 is deposited and again process of loan started and it goes on and on.

This process of deposit and its reserve continues in economy forever .

•        Total money supply ----------M+.8M+M*.8*.8+………………………+..{.8}.

•      Value of total money supplied in the economy comes out to be 5M/3 and this money supply 5M/3 is greater than Monetary base ie M.
•         This creation of 5M/3 out of M is because of the process of fractional reserve banking.

IS MONEY MULTIPLIER APPLICABLE ALL THE TIMES:

No, If all depositors withdraw and if money multiplier fails then it will lead to bank run 

                                                     but 

 It is assumed that all depositors will not withdraw deposit at the same time.

                                                    

Money Multiplier vs Money velocity  (RBI):

• MONEY velocity is not the same thing as money multiplier. 
• Money multiplier explains the process in which the “base money ie M0” multiplies in the banking system to the stock of broad money (M₃) at any point of time. 
• Money Velocity refers to the number of times the available money stock change hands in an economy to create nominal GDP.
• While money multiplier could be derived as “broad money/reserve money”, velocity is derived as “nominal GDP/broad money”.

PYQ in UPSC :

Q. The money multiplier in an economy increases with which one of the following? [2019]

a) Increase in the cash reserve ratio

b) Increase in the banking habit of the population

c) Increase in the statutory liquidity ratio

d) Increase in the population of the country

Ans: b) Increase in the banking habit of the population

Q. The money multiplier in an economy increases with which one of the following? [2021]

a)  Increase in the cash Reserve Ration in the banks

b) Increase in the Statutory Liquidity Ratio in the banks

c) Increase in the banking habit of the people

d) Increase in the population of the country

Ans: c) Increase in the banking habit of the people

Different Monetary ratios: Currency Deposit Ratio, Cash Deposit ratio, Credit Deposit Ratio, Reserve Deposit Ratio

 

DIFFERENT TYPE OF MONETARY RATIOS:

The Currency Deposit Ratio (cdr):

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

Significance of Currency Deposit Ratio (cdr): 

• It reflects people’s preference for liquidity. 
• It is a purely behavioral parameter which depends, among other things, on the seasonal pattern of expenditure. 
• For example, cdr increases during the festive season as people convert deposits to cash balance for meeting extra expenditure during such periods.

Cash Deposit ratios (CDR):  

Cash-deposit ratio of scheduled commercial banks is the ratio of cash in hands and balances with the RBI as percentage of aggregate deposits.

                                 

Here, cash in hand is actually physical currency available with bank to be given as loan 

Balance with RBI is nothing but CRR balances with RBI. 

Significance of Cash Deposit Ratio :

• It indicates how much cash banks maintain for each rupee of deposit they accept. 
• Cash Deposit Ratio will always be higher than CRR as settlement balance is also included. 
• The use of plastic money, Internet payments, electronic funds transfer, and so on, reduces this ratio near to CRR.

Credit Deposit Ratio: 

• The credit-deposit ratio is the ratio of assets in the form of loans disbursed and liabilities of the banks in the form of deposits.
• Credit-deposit ratio  is used for measuring a bank’s liquidity.
• The  ratio helps in assessing a bank’s financial health.
• Higher credit-deposit ratio indicates that there is strong demand for credit in the economy.
• Lower credit-deposit ratio indicates that there is poor credit growth in the economy.

The Reserve Deposit Ratio:

• When the money is deposited with the bank ,certain amount of that deposit is kept as reserves, giving rest of the amount in the form of loans.
• Reserve money consists of two things – vault cash in banks and deposits of commercial banks with RBI. 
• Reserve deposit ratio (rdr) is the proportion of the total deposits commercial banks keep as reserves.
• For illustration: CRR+SLR ie 4.5 % +18%=22.5 ie out of 100 Rs deposited with bank ,22.5 Rs are to be reserved with the bank and rest 77.5 Rs are to be given to the customers in the form of loan.
• Higher the Reserve Deposit Ratio, lesser is the money with bank to give in the form of loans and hence less liquidity in the economy.

Monetary Base,Correlation between M0, M1, M2 and M3,Money Supply vs Monetary Base

                                 

Monetary Base / Reserve Money Monetary Base (M0):

• Monetary base is the total liability of RBI which is actually the money created /printed in the economy by RBI.
• As per the RBI Act, the only liability of the Issue Department is 'Notes in Circulation' but If we analyse the balance sheet of RBI, the major liabilities are :

Monetary base formula:

Notes in circulation + Reserves with RBI .

• So, the monetary base (or M0) is the total amount of a currency that is either in general circulation or in the form of commercial bank deposits held in the central bank's reserves.
• This measure of the money supply is not often cited since it excludes other forms of non-currency money that are prevalent in a modern economy.
• It is also said to be High powered money or powerful money as it refers to the currency that has been issued by the Government and Reserve Bank of India.

WHY  M0 (Monetary base) is LIABILITY ON RBI :

• If citizen produces a currency note to RBI the latter must pay her value equal to the figure printed on the note. 
• Similarly, the deposits are also refundable by RBI on demand from deposit-holders. 
• These items are claims on RBI and hence are considered to be the liability of RBI.

Correlation between M0(Monetary base), M1, M2 and M3:

• In a modern economy, M0 is transformed to M1, M2 and M3 through the process of Money multiplier (explained in blog) which is more relevant to common man.
• Money supply ie M3 can be higher than monetary base as the M0 is transformed from M0 to M3 through the process of money multiplier.

For understanding purposes :

M0-Reserve money as on Feb 2024 is 45 trillion while value of M3 is approximately 246 trillion .

Image: RBI Website

Money Supply vs Monetary Base :

• MB is the total value of the currency in circulation and reserve balances, whereas the money supply refers to the quantity of currency with public  and checkable or demand deposits.
• Reserve balances are not included in the money supply calculation, showing that the money supply concept is more about the money available for immediate use. 

MONEY SUPPLY: M1, M2, M3, M4, Narrow Money vs Broad Money

 

                               MONEY SUPPLY:

 

Monetarism (also referred to as “monetarist theory”):

• It is a fundamental macroeconomic theory that focuses on the importance of the money supply as a main driver for economic growth. 
• According to the theory, monetary policy is a much more effective tool than the fiscal policy for stimulating the economy or slowing down the rate of inflation. 

MONEY SUPPLY: 

• The money supply is the total amount of money—cash, coins, and balances in bank accounts—in circulation among the public at a particular point of time. 
• The money supply determines the health status of an economy.
• Any change in the money supply directly affects and determines production, employment, and price levels in the economy.

Different Measures of Money Supply:

• Money supply is classified into various measures on the basis of its functions.
• To adequately capture the variety of assets, Post 1998,  the RBI publishes figures for four alternative measures of money supply, viz. M0, M1, M2 and M3 etc
• Different class of Money has different impact upon the Economy so effective predictions can be made about the likely effects of changes in the different components of money supply. 
• For example, if M1 is increasing firstly it can be reasonably expected that people are planning to make a large number of transactions. On the other hand, if  M3 is increasing , it can be validly concluded that people are planning to save more and accordingly consume less.

01.

M1 = CU + DD +other deposits with RBI, 

where, 

CU = Currency (notes plus coins) held by the public and

DD = Net demand deposits held by commercial banks.

The word ‘net’ implies: Only deposits of the public held by the banks are to be included in money supply. 

Other’ deposits with RBI comprise mainly: 

(i) deposits of quasi-government and other financial institutions including primary dealers, 

(ii) deposits of foreign Central banks and Governments, 

(iii) accounts of international agencies such as the International Monetary Fund, etc.

(IV)Deposits of the Reserve Bank of India Employees' Provident, Gratuity, Super-annotation and Guarantee Funds. All these accounts are maintained with RBI.

M1 excludes:  

1. India’s deposits with IMF, World bank, Foreign Government etc. 2. Interbank deposits.

*******************The interbank deposits, which a commercial bank holds in other commercial banks, are not to be regarded as part of money supply.

02. 

M2 = M1 + Savings deposits with Post Office savings banks

• The reason why money supply M2 has been distinguished from M1 is that saving deposits with post office savings banks are not as liquid as demand deposits with commercial and cooperative banks as they are not chequable accounts. 
• However, saving deposits with post offices are more liquid than time deposits with the banks.

03. 

M3 (Money aggregate) = M1 + Net Time deposits with commercial banks (Fixed deposits, Recurring deposits).

NOTE: M3= M1+time and NOT M3=M2+time.

• M3 captures the complete balance sheet of the banking sector and it is the broader form of money.
• M3 is the most commonly used measure of money supply in an Economy. 
• It is also known as aggregate monetary resources. 

04.

M4 = M3 + Total deposits with Post Office savings organisations *(excluding National Savings Certificates)  *meaning those Post Office “time deposits” and “recurring deposits” also but excludes national savings certificate etc.

• M4 is least Liquid Money.
• It is the broadest money in the economy comprising of almost total money components in the economy.

NARROW MONEY :

• M1 and M2 are known as narrow money . 
• These are the most liquid 

BROAD MONEY:

• M3 and M4 are known as broad money. 
• These are the least liquid money.

In terms of Liquidity ,

•  M1 is most liquid and easiest for transactions whereas M4 is least liquid of all. 
• M2 and M4 that include post office savings banks deposits are not very widely used. 
• The reserve money and M3 aggregates are presented both for the components (liabilities) and sources (assets).

CLASSIFICATION OF MONEY,Full-Bodied Money,Representative Full-bodied Money,Credit money,Optional Money

 

MONEY :

Money is an economic liquid asset used to buy goods and services .It  functions as a generally recognized medium of exchange for transactional purposes in an economy. Currency is the basis of economy in the sense that its movement in the economy is the barometer of the health of economy.

CLASSIFICATION OF MONEY :

Money can be classified on various parameters like :

• Liquidity of different money forms EG M0.,M1,M2,M3....
• Backing of money by different reserves in the form of metal or foreign currency and its relationship between the value of money as a commodity and the value of money as money.

Based upon its money as a commodity and the value of money as money, It is classified as Full-bodied Money, Representative Full-bodied Money and Credit Money.

Full-Bodied Money: 

• Full-bodied money refers to any unit of money, whose intrinsic value and face value are equal. 
• For example, During the colonial period, 1 rupee coin was made of silver metal and its monetary value was equal to its commodity value.

The value of silver constituting this coin during Colonial era was 2 Annas .

Representative Full-bodied Money: 

It refers to money which is usually made of paper but 100% backed by metallic reserve of gold or silver.

The value of representative full-bodied money (face value of currency) is much higher than its value as a commodity (paper). 

Credit money:    

• It refers to the money whose intrinsic value (as a commodity) is much lower than its face value, i.e. Money Value (2000 Rs) > Commodity Value (value of paper). 
• In case of credit money, the currency note is not 100 % backed by any metallic reserve or any foreign currency.
• In the modern economies, countries are having currencies in the form of credit money .

                              

For example, face value of Rs 2000 note is Rs 2000, but we would get a much lower value if we sell the note as a piece of paper. Examples are Token coins ,currency notes ,Credit cards, bank deposits.

Optional Money  : 

• Money which is ordinarily accepted by the people for final payments, but has no legal sanction behind it.
• This type of money does not have status of legal tender as it is not have guarantee of central bank.
• No one can be forced to accept them but they are generally accepted because people have confidence in the credit of these types of paper.
• Credit instruments like cheques, bank drafts, bills of exchange, promissory notes etc. are optional money. 

 

If you see the cheque, you will realize that this cheque has the owner's signature unlike the Currency note which has promissory note form the central bank.

FIAT MONEY, LEGAL TENDER, FIAT MONEY vs LEGAL TENDER

 

Fiat Money:

• Fiat money is currency which has been declared to be a legal tender by the government. 
• Fiat currency does  not have any intrinsic value nor it is backed by any physical commodity.
• In the modern Economies, fiat currency is the prevalent mode of currencies which is dominantly in the form of paper. 
• Every currency note bears on its face a promise from the Governor of RBI that "I promise to Pay the bearer the sum of rupees ............ ". 
• This promise entitles the piece of paper a Fiat currency.

• The same is also true of coins. 
• Currency notes and coins are therefore called fiat money.
• The value of fiat currency is derived from the relationship between supply and demand rather than the value of the material that the money is made of. 
• The value of fiat currency is also affected by the inflation in the economy.

Legal tender:

• It is the payment method that is recognised by the law of the land, as valid for payment of debt. 
• The RBI Act of 1934, which gives the central bank the sole right to issue bank notes, states that “Every bank note shall be legal tender at any place in India in payment for the amount expressed therein”.
• They are also called legal tenders as they cannot be refused by any citizen of the country for settlement of any kind of transaction.
• Cheques ,instruments like commercial bills and virtual currency, however, can be refused by anyone as a mode of payment so these  can’t be used as legal tender money.
• When the government withdraws legal tender status to a currency denomination, it cannot be used for settling transactions. 
• Ex. Old currencies after demonetization in India.

Legal tender can either be limited or unlimited in character.

Unlimited Legal tender:

• Currency that can be used for settlement of any amount of debt. 
• In India, all currency notes are unlimited legal tender.

Limited Legal Tender:

In India, coins function as limited legal tender. Coins in India can be used for settlement of dues with certain limitation as mentioned below :

• a coin of any denomination not lower than one rupee, for any sum not exceeding one thousand rupees;
• a half-rupee coin, for any sum not exceeding ten rupees;
• any other coin, for any sum not exceeding one rupee:

LEGAL TENDER VS FIAT MONEY :

• Legal tender refers to a specific form of payment that is recognized by law of the land while fiat money refers to a type of currency that is backed by the government's fiat. 
• In other words, legal tender is a legal requirement for debt settlement, while fiat money is a type of currency that the government has issued.

BUSINESS CYCLE: EXPANSION, SLOWDOWN, CONTRACTION, RECESSION, DEPRESSION, RECOVERY

 

TRADE /BUSINESS CYCLE: 

The study of ups and downs in the Economy is said to be trade cycle of an Economy.

Expansion: 

• Expansion is the phase of the business cycle where real GDP grows accompanied by a rise in employment, growth and investments.
• PEAK in the Economy is that point of time in the Economy when GDP growth rate is at its highest point.

SLOWDOWN: 

• The phase of the business cycle characterized by decrease in growth rate.
•  The Size of GDP increases as the GDP growth rate still remains positive.
• GDP growth rate in : 2017-18-----------------7%,2018-19-----------------6% and 2019-20--------------5% is slowdown as there is slowdown in the growth rate.

CONTRACTION: 

• GDP growth rate is negative in one quarter resulting in decrease in the size of GDP. 
• Ex: Q1=+1%, Q2=-1%, Q3=+3%, Q4=.5%

RECESSION: 

• It is significant decline in economic activities reflected through reduction in GDP growth or negative growth rate, increase in unemployment rate , decrease in demand ,fall in profits  etc,
•  Technically the slowdown is typically for two quarters. 
• Ex.Q1=+1%, Q2=-1%, Q3=-3%,Q4=.5%

DEPRESSION: 

• Depressions is an advanced form of recession lasting longer than three years, resulting in a drop in annual GDP of at least 10%.
• It is characterized as a dramatic downturn in economic activity in conjunction with a sharp fall in growth, employment, and production. 
• The world has experienced depressions in 1930 and 2008.

TROUGH: 

Trough is negative peak of a business cycle where activity is bottoming, before a rise.

RECOVERY:

•  An economic recovery follows after the recession and leads into a new expansionary business cycle phase. 
• It is sustained period of improving business activity characterized by a rise in (GDP), incomes, and employment rates.

MICROECONOMICS vs MACROECONOMICS

 

MICROECONOMICS AND MACROECONOMICS:

As the subject matter of economics, Economics  has been studied under two broad branches:

●        Microeconomics and

●        Macroeconomics.

MICROECONOMICS:

• In microeconomics, we study the behavior of individual economic agents in the markets .
• Microeconomics can be about a sector, a particular region, group of people only rather wholistic purview of Economy.
• Micro-Economics is about how prices and quantities of goods and services are determined through the interaction of individuals in these markets.

• Example. Odd and Even formula for vehicles in Delhi can be an example of microeconomics as it affected auto sector in the NCR region only.

MACROECONOMICS:

• Macroeconomics studies the aggregate economy’s behaviour  in a wholistic manner at the National level .
• The parameter of measurement are Inflation, National income, Growth Rate and GDP.
• Both microeconomics and macroeconomics are dependent and upon each other.

• For example, Slow down in a particular sector is microeconomy but slowdown of GDP growth rate is macroeconomics .