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Chapter 14: Problem 20

What is the formula for the money multiplier?

Short Answer

Expert verified
The basic formula for the money multiplier (MM) is: \(MM = \frac{1}{RR}\), where RR represents the reserve ratio as a fraction.

Step by step solution

01

Define the Reserve Ratio

Reserve ratio (RR) is the percentage of deposits that banks are required to hold as reserves, either by regulation or by their own policy. It is expressed as a fraction, so if the reserve ratio is 20%, it will be represented as 0.2.
02

Calculate the Money Multiplier using the reserve ratio

The basic formula for the money multiplier (MM) is: \[MM = \frac{1}{RR}\]
03

Example

Let us consider an example where the reserve ratio is 20% (or 0.2). Using the formula from step 2, we can calculate the money multiplier: \[MM = \frac{1}{0.2}\]
04

Solve for the Money Multiplier

Continuing with the example from step 3, calculate the money multiplier: \[MM = 5\] This means that for every 1 unit of currency deposited in the banking system, the money multiplier (in this example) will create a total of 5 units of currency in the economy, through various loans and deposits.

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Most popular questions from this chapter

What is the risk if a bank does not diversify its loans?

Can you name some item that is a store of value, but does not serve the other functions of money?

Humongous Bank is the only bank in the economy. The people in this economy have \(\$ 20\) million in money, and they deposit all their money in Humongous Bank. a. Humongous Bank decides on a policy of holding 100\% reserves. Draw a T-account for the bank. b. Humongous Bank is required to hold \(5 \%\) of its existing \(\$ 20\) million as reserves, and to loan out the rest. Draw a T-account for the bank after it has made its first round of loans. c. Assume that Humongous bank is part of a multibank system. How much will money supply increase with that original \(\$ 19\) million loan?

How do banks create money?

If you take \(\$ 100\) out of your piggy bank and deposit it in your checking account, how did M1 change? Did M2 change?
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