Explain the Mechanism Behind the Money Multiplier. How Can the Monetary Authorities Influence Its Size and the Supply of Money?
This essay will explain and illustrates the key mechanism behind the money multiplier and explore how monetary authorities can influence its size and affect the money supply in the economy. Firstly, an introduction on money measure will be presented. Secondly, the mechanism behind money multiplier will be presented by using equations to explain the cyclical changes in the multiple factor. Thirdly, the examination of the money multiplier in the current economic climate will be put forward.
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Fourthly, an explanation on the open market operation, discount window and the reserve ratio will be presented to convey the influence in the size of money supply. Finally, this essay will conclude with an overview of the essay. According to Miller & VanHoose (1997) states distinctive measures can determine the money supply (M) through monetary aggregates, M2 and M4. The money measure M2 is the sum of deposit within retail bank and building societies plus currency held by household’ (Thomas, 2010). This can be expressed as: M4 provides a broader measure of money.
This includes deposits of wholesale banks, WD, plus certificate deposit, C and additional M2 (Thomas, 2010). This can be expressed as: These money measures above indicate the level of liquidity held in the money supply, however the broader the measure, the less liquid it holds. The interaction between the Bank of England, Household and commercial bank and the behaviour defines money supply in form of currency deposit ratio and the reserve ratio (Thomas, 2010). The money supply can be expressed as: M = CU = D The money multiplier holds a ‘mathematical relationship between the monetary base and the money supply of an economy’.
The monetary base/high powered money ‘is the sum of currency in circulation plus reserves in the banking system’ (Howell & Bain, 2008). The money multiplier (mm) can be expressed as: It explains the cyclical process in the amount of cash generated by the commercial banks (Business Dictionary, 2010). For example, if an individual deposited ? 100 and initially the reserved ratio was 20%, the bank would have to reserve ? 20 and the remaining ? 80 deposit can be converted into loans or credit. Therefore, the monetary base holds ? 180. Similarly, if another customer deposits ? 00, the bank would have to reserve ? 80 and may convert the remaining ? 320 into loans or purchase government securities (Howell & Bain, 2008). Nevertheless, it should be noted that the change in the money multiplier depends on the reserve requirement ratio and the public’s willingness to deposit currency (Vasudevan, 2003). For instance, when the depositor keeps less currency it will have an effect on deposit as it will be multiplying more. In comparison, if the depositor holds more currency then less multiple deposits will occur (Ireland, 2010).
Conversely, the banking system are required to keep a portion of the depositor funds for precautionary circumstances and ‘the rest may be converted in to loans, thereby increasing the available cash by a factor that is a multiple of the initial deposit’ (Business Dictionary, 2010). For example, assume that the money supply in the economy is ? 900 billion, the total deposits are ? 500 billion and the reserved required is 12%. The calculation for mm is the following: In this example above, a ? 1 increase in Monetary Base/high powered money leads to a ? 2. 20 increase in Money supply.
However, according to Vasudevan (2003) states ‘the changes in reserve requirements can be captured in the multiplier. The money multiplier tends to rise when the reserve requirement ratio is reduced, indicating the greater multiple expansion of bank liabilities facilitated by the reduced ratio. ’ Nevertheless, it is evident that reserve level (r) and the money supply (M) corresponds as, ‘M falls when r rises, and M rises when r falls’ (Ireland, 2010). For instance, suppose the bank reserve ratio to 10%, a ? 1 increase in monetary base leads to a ? 2. 30 increase in money supply.