The Money Multiplier: Factors and Effects

The Money Multiplier

With just a little mathematical manipulation, we can express the real-world money multiplier (m) as a function of the required reserve ratio (RRR), the excess-reserves ratio (ER/D), and the currency-deposit ratio (C/D). To find m, all we need are the values of the C/D and ER/D ratios. (We already know that RRR = .10, or 10%.) Alternatively, we could compute m with values for C, D, and ER.

Studying the multiplier effect is crucial because, unlike what basic economics states, the money supply is not fully controlled by the Fed. Instead, the Fed does have access to the monetary base, but the multiplier effect will depend on the monetary decisions of financial institutions and the general public.

Factors Affecting the Money Multiplier

Several factors can influence the money multiplier:

1. Increased Underground Activity: The multiplier will decrease because transactions conducted illicitly will be in cash, thus increasing the currency-deposit ratio. Less of people's money will be in banks to lend out, so the financial system will have fewer deposits to multiply.
2. Forbidding Payment on Checking: The multiplier will also decrease in this situation because, in the absence of interest payments on checking accounts, the opportunity cost of holding cash will decrease. This will increase the currency-deposit ratio.
3. Interest Rates on Savings Fall Relative to Checking: As the interest rates on time deposits decrease, people will feel that they are not being compensated enough for the compromise in liquidity that they have to forgo. In that case, they will switch over to checking accounts because they are getting a relatively favorable interest rate and liquidity incentive. Due to this, the currency-deposit ratio will also increase, and the multiplier will decrease.
4. Penalty Is Eliminated: People will withdraw more cash as there is no disincentive to keep the money in savings accounts. As a result, the currency-deposit ratio increases, and we will get a weaker multiplier.
5. Fed Response: The Fed can reduce the reserve requirements to offset the weaknesses that affected the multiplier.
6. Uncertainty: The currency-deposit ratio will rise as people rush to pull their money out of the banks. Also, banks will hold onto more excess reserves as the economy loses creditworthiness - both will reduce the multiplier.
7. Electronic Systems Increase: The currency-deposit ratio will decrease as people will need less paper money to accommodate their transactions. Deposits will also increase, and that should increase the multiplier.