Wednesday, 22 August 2012

Money Multiplier, Monetary Deepening and Monetization of the Economy

Money Multiplier is the ratio of M3 to Mo, i.e.the ratio of the change in money (deposits and currency) to the change in bank reserves, which results from an injection of additional reserves into the banking system. Most often, it measures the maximum amount of commercial bank money that can be created by a given unit of central bank money. To explain this with an example:

So, to calculate the impact of the multiplier effect on the money supply, we start with the amount banks initially take in through deposits and divide this by the reserve ratio. If, for example, the reserve requirement is 20%, for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend out the remaining $64. This cycle continues - as more people deposit money and more banks continue lending it - until finally the $100 initially deposited creates a total of $500 ($100 / 0.2) in deposits. This creation of deposits is the multiplier effect. 4

The higher the reserve requirement, the tighter the money supply, which results in a lower multiplier effect for every dollar deposited. The lower the reserve requirement, the larger the money supply, which means more money is being created for every dollar deposited. 4Therefore as the name suggests, the change in money is typically a multiple of the initial change in bank reserves.This mainly depends on the percentage of deposits that the banks are supposed to keep in reserves.  

According to the Economic Survey 2012, the higher rate of expansion in 'currency with the public' and reserves as compared to that in deposits, led to a decrease in the money multiplier during 2010-11. During 2011-12, the money multiplier has generally shown an increasing trend on account of M0 registering a lower growth vis-a-vis M3. 1

Monetary Deepening: Monetary deepening generally means an increased ratio of money supply (M3) to GDP. It refers to liquid money- the more liquid money is available in an economy, the more opportunities exist for continued growth. It refers to the increased provision of financial services with a wider choice of services geared to all levels of society.
Monetary Deepening can also play an important role in reducing risk and vulnerability for disadvantaged groups, and increasing the ability of individuals and households to access basic services like health and education, thus having a more direct impact on poverty reduction.5
According to Economic Survey 2012, 'monetary deepening' registered a rise from 42.6 per cent in 1990-91 to 78.4 per cent in 2010-11. The rise may be attributed to the spread of banking services in the country and development of the financial sector.  

The monetization of the economy (as measured by the ratio of average M1 to GDP) has also shown an upward trend, albeit at a slower rate, over the same period. In 1990-91, this ratio was 14.9 per cent and it increased to 20.1 per cent in 2010-11.

1. Economic Survey 2012, pgs 93

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