The money multiplier in an economy increases with which one of the following?

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Accepted Answer

Banks create money by making loans. A bank loans or invests its excess reserves to earn more interest. A one-rupee increase in the monetary base causes the money supply to increase by more than one rupee. The increase in the money supply is the money multiplier. Cash Reserve Ratio (CRR) = Percentage of deposits which a bank must keep as cash reserves with the bank. Apart from the CRR, banks are also required to keep some reserves in liquid form in the short term. This ratio is called Statutory Liquidity Ratio or SLR. Money Multiplier = 1/CRR Let us assume that our bank starts with a deposit of Rs 100 made by Mr. X. The reserve ratio is 20%. Thus our bank has Rs 80 (100 – 20) to lend and the bank lends out Rs 80 to Mr. Y, which shows up in the bank’s deposits in the next round as liabilities, making a total of Rs 180 as deposits. Now our bank is required to keep 20 per cent of 180 i.e. Rs 36 as cash reserves. Recall that our bank had started with Rs 100 as cash. Since it is required to keep only Rs 36 as reserves, it can lend Rs 64 again (100 – 36 = 64). The bank lends out Rs 64 to Mr. Z. This in turn shows up in the bank as deposits. The process keeps repeating itself till all the required reserves become Rs 100. The required reserves will be Rs 100 only when the total deposits become Rs 500. This is because for deposits of Rs 500, cash reserves would have to be Rs 100 (20 per cent of 500 = 100). From the above example, it is clear that the money multiplier in the economy increases with the banking habit of the people not only an increase in the population. Increase in banking habit leads to lower cash deposit ratio and hence increase in money multiplier. But this money creation is limited by CRR, money supply increases from Rs 100 to Rs 500. Given a CRR of 20%, the bank cannot give a loan beyond Rs 400. Hence, requirement of reserves acts as a limit to money creation. So, as CRR or SLR is increased by RBI, money multiplier is decreased, as there would be less amount of money for credit creation with the banks. Hence correct option is c. Source Attribution: Vision IAS Economy Study Material, Vision IAS QRM document: Money