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The Money Multiplier Is An Economic Mode

Jul 4

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The Money Multiplier Method

As a budding economist you may be familiar with the concept of the money multiplier, which explains how an increase in a country’s reserves leads to a much larger increase in the country’s money supply. This idea is a simple but powerful one.

To understand how it works, you need to know a bit about the difference between a country’s Monetary Base and its Money Supply. The Monetary Base refers to the total amount of physical cash in circulation (including coins and notes) as well as bank reserves. The Money Supply, on the other hand, is a broader measure that includes both the Monetary Base and checkable or near-checkable bank deposits.

The money multiplier is an economic model of how credit creation works in a fractional reserve banking system. Essentially, it posits that each time a bank lends out some of its reserves it will create deposits that can be used to repay the loan, and this will happen over and over again until the desired amount of excess reserves is reached.

Many introductory economics textbooks use the money multiplier as an explanation of the link between banks and central banks. However, it is important to note that most major central banks no longer attempt to control the money supply directly through monetary policy; instead, they focus on controlling inflation by adjusting interest rates.

For example, if the monetary base is $1,000 and the Money Multiplier is 5 (or 0.5), then for every unit of money that enters the banking system as currency in circulation or reserves, 5 units will be created in the economy through loans and deposits. This process creates economic growth and a strong foundation for financial markets. Moreover, it can help reduce the effects of demand-type shocks by responding more quickly to changes in inside money than outside money. It can also help stabilize prices through a reduction in interest rates. Consequently, the Money Multiplier is an essential tool for a central bank’s monetary policy.