Money Multiplier

The money multiplier approach to the determination of money supply was propounded by economists Milton Friedman and Anna Schwartz.
This approach explains the relationship between the monetary base and the total money supply in an economy.
The money multiplier describes how an initial change in the monetary base, also known as high-powered money, results in a proportionately larger change in the overall money supply.
High-powered money consists of currency in circulation with the public and the reserves held by commercial banks with the central bank. For example, if the money multiplier is twenty, it implies that a one-rupee increase in reserve money will ultimately lead to a twenty-rupee increase in the total money supply in the economy.
This expansion occurs through repeated cycles of bank lending and redepositing.
The money multiplier is defined as the ratio of broad money to reserve money.
In India, broad money is represented by M3, while reserve money is represented by M0.
Thus, the money multiplier shows how effectively the banking system converts reserve money into total money supply.
The value of the money multiplier depends largely on the reserve ratio maintained by banks and the currency-holding behaviour of the public.
When the reserve ratio is lower and people prefer to keep money in banks rather than holding cash, the money multiplier tends to be higher.

The money multiplier plays an important role in the conduct of monetary policy.
When the central bank wants to control inflation, it can increase the reserve requirements imposed on commercial banks.
Higher reserve requirements reduce the amount of money that banks can lend, which lowers the money multiplier and restricts the expansion of money supply.
Conversely, when the central bank aims to stimulate economic growth, it may reduce reserve requirements.
Lower reserve requirements increase the lending capacity of banks, raise the money multiplier, and allow greater expansion of money supply through credit creation.
Thus, by influencing reserve requirements and liquidity conditions, the central bank indirectly affects the money multiplier and, through it, the overall level of money supply in the economy.