Money Multiplier and Reserve Ratio in Banking

The money multiplier and reserve ratio are two key concepts in banking that determine how much money is available in the economy. The money multiplier is a formula used to calculate the amount of money in circulation based on the amount of reserves held by commercial banks.

A commercial bank's reserve ratio is the percentage of deposits that must be held in reserve and not lent out. In the United States, the reserve ratio is set by the Federal Reserve at 10% for most banks.

The reserve ratio affects the money multiplier, as it determines how much of a bank's deposits can be lent out. For example, if a bank has $100 in deposits, it must hold $10 in reserve, leaving $90 to be lent out.

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The money multiplier is a concept that helps us understand how the money supply changes in response to a change in the monetary base. It's a simple relationship that can be expressed as M = D + C, where M is the money supply, D is deposit accounts, and C is currency held by the public.

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The money multiplier is calculated as the ratio of the money supply to the monetary base. This ratio is determined by two other ratios: the ratio of commercial banks' reserves to deposit accounts (R/D), and the ratio of currency to deposits (C/D).

The money multiplier theory assumes that these two ratios are exogenously determined constants, which means they can be controlled by the central bank. This allows the central bank to control the money supply by controlling the monetary base through open-market operations.

If the monetary base increases by $1, the money supply will increase by (1 + C/D) / (R/D + C/D). This is the central content of the money multiplier theory.

In some cases, the relationship is simplified by assuming that cash does not exist, so the currency-deposit ratio C/D equals zero. In this case, the money multiplier simplifies to 1 / (R/D).

The money multiplier can be empirically measured as the ratio of some broad money aggregate like M2 over M0 (base money).

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The money multiplier is a crucial concept in understanding how banks create money. The money multiplier, m, is the inverse of the reserve requirement, R.

To calculate the money multiplier, you need to know the reserve ratio. The reserve ratio is the percentage of deposits that a bank is required to keep in reserve. For example, if the reserve ratio is 11%, a bank with deposits of $1 billion would be required to keep $110 million on reserve.

The formula for the reserve ratio is: Reserve Requirement = Deposits × Reserve Ratio. This means that if a bank has deposits of $1 billion and a reserve ratio of 11%, it would be required to keep $110 million on reserve.

A reserve ratio of 5% is expected to result in a money multiplier of 20, because if a bank has deposits of $1 million and a reserve ratio of 5%, it can lend out $20 million.

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In most legal systems, a bank deposit is not a bailment, meaning the funds deposited are no longer the property of the customer. The funds become the property of the bank, and the customer receives an asset called a deposit account, which is a liability on the bank's balance sheet.

Regulatory frameworks are designed to prevent bank runs, which can occur when depositors withdraw their funds in large numbers, leaving the bank with insufficient reserves. Central banks have been created to address these problems and maintain public confidence in the banking system.

Banks are legally authorized to issue credit up to a specified multiple of their reserves, but reserves available to satisfy payment of deposit liabilities are less than the total amount the bank is obligated to pay. This is known as fractional-reserve banking.

Here's a breakdown of how reserve requirements work:

The central bank can raise funds for banks during a crisis by lending to them or by selling assets, but if creditors are afraid the bank is running out of reserves or is insolvent, they have an incentive to redeem their deposits, which can precipitate a crisis.

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Banks need to maintain a minimal reserve ratio to avoid defaulting on their obligations.

Banks manage liquidity by maintaining a stock of low-cost and reliable sources of liquidity, such as demand deposits with other banks, high-quality marketable debt securities, and committed lines of credit with other banks.

These sources of liquidity are managed with targets, just like reserves.

The ability to borrow money reliably and economically is crucial for a bank's liquidity.

Confidence in a bank's creditworthiness is important to its liquidity, which means the bank needs to maintain adequate capitalization and control its exposures to risk.

A bank's liquidity can be threatened if creditors doubt the bank's assets are worth more than its liabilities, causing a bank run to occur.

Banks conduct maturity analysis of all their assets and liabilities to identify large future net outflows of cash and respond before they occur.

Scenario analysis may also be conducted, including stress scenarios such as a bank-specific crisis.

Here are some common ways banks respond to a low actual reserve ratio:Selling or redeeming other assets, or securitization of illiquid assetsRestricting investment in new loansBorrowing funds (whether repayable on demand or at a fixed maturity)Issuing additional capital instrumentsReducing dividends

The cash reserves held by ANZ National Bank Limited, for example, are NZ$3,010m, and the demand deposits of the bank are NZ$25,482m, for a cash reserve ratio of 11.81%.

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The money multiplier is a crucial concept in understanding how monetary policy affects the economy. It's the ratio of the money supply to the monetary base.

A higher reserve ratio reduces bank lending, which in turn reduces the money supply. This is a deflationary monetary policy.

The Central Bank can influence the money multiplier by changing the reserve ratio. This is a key tool for implementing monetary policy.

If the Central Bank demands a higher reserve ratio, banks will have to hold more of their deposits as reserves, rather than lending them out. This reduces the money supply.

The money multiplier is important because it shows how changes in the monetary base can lead to changes in the money supply.

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The money multiplier is a powerful tool in banking, and it's based on different types. There's the fractional reserve multiplier, which is the most common type.

This type of multiplier is based on the reserve requirement, which is the percentage of deposits that banks must hold in reserve. In the United States, for example, the reserve requirement is around 10%.

Banks can lend out the remaining 90% of deposits, and these loans are then deposited into other banks, creating a multiplier effect. This is how the money supply grows.

The loanable funds multiplier is another type, which focuses on the supply of loanable funds in the economy. It's based on the interest rate, which affects the amount of money people are willing to borrow and lend.

As the interest rate falls, more people are willing to borrow, and the money supply grows. This is because lower interest rates make borrowing cheaper.

The currency multiplier is a less common type, which occurs when banks lend out cash instead of deposits. This can happen when people withdraw cash from their accounts.

For example, if a bank lends out $100 in cash, it can create a multiplier effect of $100 x 10 = $1,000 in deposits.

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The reserve ratio plays a crucial role in US monetary policy and the country's money supply.

Lowering the reserve ratio allows banks to lend out more money, which can stimulate economic growth.

The Federal Reserve Board's Regulation D specifies a series of reserve requirements that commercial banks must follow, including the reserve ratio.

This ratio determines the percentage of a bank's deposits that must be kept in cash on reserve, which is a key aspect of monetary policy.

The Fed may increase the reserve ratio to control inflation and reduce the money supply, as a higher ratio means banks have less money to lend.