What is Credit Expansion Multiplier?



The end result of a primary deposit into the credit creation activity by the banking system can be determined by using the credit expansion multiplier.

Modifications in the Multiplier:

To make it more realistic, the simple credit expansion multiplier needs to be modified by making adjustment for the possible leakages.

Two types of leakages are important.

1. Cash drain, and

2. Desired excess reserves

Cash Drain:

It refers to that part of bank loans which does not come back as primary deposit in the banking system when some people want to retain them in currency or cash form. Average cash drain is measured in terms of the currency-deposit ratio C/D. Let it be denoted by K. Then, K = C/D

Desired Excess Reserves: In the simple model, it is assumed that the entire excess reserve (ER) is lent out by the banks.

But, in reality, banks may retain a margin of excess reserves at all times to maintain a higher liquidity position under the precautionary motive.

This excess reserves so desired serve as the leakage in the credit creation process. The excess reserve ratio e may be expressed as:

e = Excess Reserves/ Deposits

Taking both these factors into account, the credit multiplier (CM) may be expressed as:

CS = 1 /r + K + e

Inclusion of Time Deposits:

In a simple model, time deposits are excluded. But, in reality time deposits are important source of funds or lendable resources to the banks. The reserve requirement on time deposits is usually less than that on demand liabilities.

Let, td = ratio of time to demand deposits T/D and,

rt = reserve requirement on time deposits.

For tracing the causes of charges in the money supply, the above stated money multiplier model is of great help.

It shows that the central bank can produce its impact on monetary policy or money supply in the economy by influencing the monetary base (MB). It can also affect r in the money multiplier by altering cash reserve ratio.

But, the other parameters like currency deposit ratio, banks' desire for excess reserves, ratio of time deposits to demand deposits are not within the control of the central bank.

In essence, true money multiplier framework considers the interaction of central bank's policy decisions and the decision of the banking system as well as those of the public at large in the determination of money supply in an economy.

Hence, no firm conclusion can possibly be derived from the course of action of the central bank in determining the monetary aggregates of the economy.

The concept of money multiplier is significant in monetary economics because it shows the amount of money supply supported by a monetary base and low charges in the monetary base would translate into charges in the money stock.