Explain the mechanism of the money multiplier. How can the monetary Essay

Explain the mechanism of the money multiplier. How can the monetary authorities influence its size and the supply of money - Essay Example To this, there will be answering of the study question, â€Å"What is a Money Multiplier?† An economic view will be maintained in this study. The money multiplier is also known as the deposit or the credit multiplier. From the simple point of view, the term multiplier means the magnitude by which money supply expands and this is usually bigger than the rise in the equivalent monetary base. Thus, if the multiplier stands at 20, then it follows that an increase of $1 in the underlying monetary base will lead to a $20 rise in the supply of money. (moneyterms.co.uk, 2011) Money multipliers can be divided into several types. One of these multipliers is the deposit expansion multiplier. This type of multiplier measures by what magnitude money supply can be increased from the original deposit. Thus, the formula that shows how the deposit expansion multiplier works is as under; Where; Reserve requirement is the set deposit reserve for all commercial banks by the equivalent central bank. Taking that the set reserve requirement is 10%, then it follows that the deposit expansion multiplier is Thus, if the one applies the multiplier computed before, and taking that the excess reserves from the original deposit are $800. The potential money supply expansion (M1) is to be determined as follows: M1, which is the sum of the original deposit ($1,000) plus the $16,000 that has been created is, therefore, $17,000. Note that the formula presented is what is usually referred to as the simple money multiplier. (Morton and Goodman, 2003 p197) Under the deposit expansion multiplier there are various assumptions that have to be considered. This is to ensure that the explanations presented make sense. These are with the inclusion of the bank customer’s usage of cheques to pay each other as opposed to usage of cash, banks usually keep a particular deposits’ fraction to take care of the central bank’s reserve