The mechanism of the money multiplier Essay Example | Topics and Well Written Essays - 1000 words

The mechanism of the money multiplier - Essay Example This paper will aim to provide an explanation and illustration of the essential mechanisms behind the concept of money multiplier and intensively the manner monetary authorities can control its size and influence money supply in the economy. First, an overview of money measure will be put forth. Secondly, the mechanism in light of money multiplier will then be explained by use of symbols and equations to elaborate the cyclical variations in the multiplier factor. This will be followed by a scrutiny of money multiplier in the present economic environment which will be explained and lastly a description of the instruments of controlling money supply such as open market operation, reserve ratio and the discount window will be put in details to explain the impact in the size of money supply. A conclusion will then be provided of the general overview of the essay. The Reserve Ratio According to Valdez & Molyneux (2010, p. 111), different measures or dimensions can resolve on the issue of money supply denoted as M via monetary aggregates such as M2 and M4. The monetary aggregate M1 equals to the cash held household whilst M2 refers to the sum of deposit within the bound of retail banks and building societies in addition to the cash held by the household. M4 gives a broader measure of money which comprise of wholesale bank deposits and certificate deposits. These can be expressed as; M1 = Cash held by households M2 = M1 + retail banks and building society’s deposits M4 = M2 + wholesale banks deposits + certificate deposit The measures of money explained above shows the liquidity level of money held in supply even though broader measures indicate less liquidity held. The correlation amidst the bank of England, commercial banks and the households and the behavior which describes the supply of money in the form of deposit ratio of the currency and the reserve ratio. This can be expressed as; M = Deposits (D) + Currency deposit ratio (CU). The money multiplier main tains the mathematical connection amidst the monetary base and the economic supply of money. The monetary base or the high powered money is the summation of the currency in supply in addition to the banking system’s reserves. The money Multiplier can be articulated as; 1/rr this is the inverse of the reserve requirement ratio. For example if the reserve requirement is 20% then the multiplier effect is equal to 5. The extension of a nation’s Money supply that comes from banks ability to lend, the extent of the multiplier effect relies on the fraction of deposits that the banks are stipulated to maintain as reserves. In other terms, it is money used to make more money and is established as division of the total Bank deposits by the requirement of the reserve. The effect of the multiplier is dependent on the reserve requirement that has been set. Thus to get the effect of the multiplier on the supply of money, the first step is to get the amount banks earlier on take in v ia the deposits and then divided it by ratio of the reserve. For example, in case the reserve requirement is about 20% for each ? 200 a customer makes deposits into a bank, then ? 40 must be maintained as reserve. Nonetheless, the remaining ? 160 can be advanced to other banks customers as loans. This ? 160 is then made as deposits by the customers into other banks which simultaneously also keeps 20% or ? 32 in reserve but can loan out the remaining ? 128. This cycle goes on as more customers’ makes deposits of money and more banks proceed with the lending process until the ? 200 earlier deposited makes a total of ? 1000 (?200/0.2) in deposits. These deposits created forms the multiplier effect. It must be noted that the higher the reserve requirement, the tighter the supply of money, which eventually lead to a lower multiplier effect for every pound deposited (Cecchetti, 2008, p. 47). Subsequently, the lower the effect of the multiplier, the greater the supply of