The money multiplier explains how base money (or monetary base) grows many times through the money creation process. Every new rupiah money will multiply when circulating in the economy through the fractional banking system. The magnitude of the multiplier is 1 divided by the reserve requirement ratio.
How money multiplier works: example problems
The money creation process requires banks to multiply money. The mechanism works through deposits, loans, and bank reserves.
The reserve requirement ratio is the share of deposits that banks must hold as a reserve. For example, the central bank sets a reserve requirement ratio of 10%. That means, from every Rp100 deposit, banks can use Rp90 to lend and keep Rp10 (Rp100 x 10%) as a reserve.
Say, someone deposits Rp100 into Bank B. Bank B lends Rp90 to a debtor. The debtor uses the money to buy goods from a seller.
The seller then deposits Rp90 in money to Bank C. The bank then set aside Rp9 as a reserve (Rp90 x 10%) and lend Rp81 to its customer. The customer then uses the money to pay a professional consultant.
The professional deposits the money into Bank D. The bank D then set aside Rp8.1 (Rp81 x 10%) as a reserve and lend the remainder (Rp72.9).
The process continues until the total amount of money in the economy will increase several times. From an initial monetary base of Rp100, the money circulating in the economy increased to Rp1.000 through a money creation process. This multiple is known as a money multiplier, and we can calculate it using the formula:
Money multiplier = 1 / Reserve requirement ratio
In above case, because the base money is Rp100, thus money multiplier equals to = Rp100 x (1/10%) = Rp1.000.
Money multipliers and monetary policy
From the formula above, we know that when the central bank increases the reserve requirement ratio, the less excess reserves, the less money the bank can lend, thereby reducing the money multiplier.
The central bank usually raises the reserve requirement ratio when the economy is overheated (high inflationary pressure). To prevent hyperinflation, the central bank will raise the ratio so that it causes the weakening of aggregate demand and moderates inflation and economic growth.
Conversely, the central bank will reduce the reserve requirement ratio when implementing expansionary monetary policy. A decrease in the reserve ratio means that the higher the excess reserves so that the bank has more money to lend and encourages more money multiplier.
As more money circulates, economic liquidity increases, pushing interest rates down. Declining interest rates make borrowing costs cheaper, encouraging spending on goods and services to increase.
Increased demand for goods and services encourages businesses to increase output and recruit more workers. As a result, the economy is growing, unemployment is falling, and inflation is creeping up.
Money multipliers work through the fractional banking system. And, in fact, not all money is deposited in banks.
For example, we keep holding cash in hand instead of keeping it in the bank just in case. Other individuals may put money in a savings and credit cooperative (which is not bound by the terms of the reserve requirements). The part of a currency outside the fractional banking system is called the currency drain.
Currency drain reduces the money multipliers that banks can create. Taking into account the currency drain, we can rewrite the above money multiplier formula as:
Money multiplier = (1 + Currency drain ratio) / (Required reserve ratio + Currency drain ratio)