Money multiplier

economic-dictionary

The monetary multiplier or money multiplier is the process that allows banks to multiply money starting from an initial amount of money.

This is because banks are only obliged to keep a minimum level of money in their reserves. This minimum is called the cash ratio and is determined by each central bank. This makes it easy to create money. That is, it allows credit to flow. When credit flows, the economy advances and grows. While it is true, of course, that if credit flows too fast and uncontrollably, the economy could overheat. That is, bubbles could be created.

Money multiplier formula

The formula commonly used in macroeconomics to calculate the monetary multiplier (m) is the inverse of the cash ratio (c):

Example of the money multiplier

The monetary multiplier mechanism is very simple. Let's see an example to understand it better:

Let's imagine that Pepe makes a deposit of € 1,000 in a bank, if the cash ratio is 10%, the bank will have to keep 10% of those 1,000 euros (100 euros) and will be able to lend € 900 of that money to Maria. If the person who receives that money deposits it again in the bank, the bank saves 10% of the € 900 deposited (90 euros) and lends the remaining 810 to Doe, so on in an infinite decreasing series.

To calculate the total money that ultimately exists in the economy, we multiply the initial money by the m: 1) We calculate the monetary multiplier: m = 1/10% = 10 2) We multiply m by the initial money: € 1000 x m = € 1000 x 10 = € 10,000

Those initial € 1,000 have multiplied and now there are € 10,000 in the market.

Some might think that this money is fictitious, but if we look individually, following the example, Pepe says that he has € 1,000 in the bank and no one is going to take it away from him, María has € 900 and Fulano € 810. Therefore, that money has been created and is worth the same as the principal. What if Pepe and María wanted to get all their money out of the bank? Well, the bank could not return all their money and what is known as a bank corralito would be formed. Queues at the doors of the bank where everyone wants to get their money. The example can be extrapolated by a million, so we will be in a more real example. It is not enough for two people to go to the bank to withdraw their money, but if a bank has three million customers and two million of them come to withdraw their money, the bank fails. Therefore, the money that is created in banks is based on the trust that people have in those banks. To give greater precision when calculating the monetary multiplier, the cash in the hands of the public is incorporated. In this way, the formula closest to reality would be:

Bank reserve Multiplier effect

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