Sunday, May 17, 2009

The Money Multiplier Effect

When a Central Bank (Fed reserve in case of USA and RBI in case of India) infuses money in the system/economy, the money multiplier effect is taken into consideration.

Let me try and explain the money multiplier effect.

When a central bank infuses say Rs. 100 in the economy, only a part of it goes to the banks. Some part goes back to RBI in the form of CRR and SLR. These rates are again decided by RBI. 

So when RBI is giving bank A Rs 100.00. The Bank  A is left with Rs. 80.00 post CRR and SLR. Out of this, the Bank A will lend say Rs 75/- to a Customer X. Now this Customer X will take the loan and deposit the loan cheque in some other bank, say Bank B. Bank B will again set aside the amount for CRR and SLR. And after that will lend Rs 60.00 to Customer Y. Customer Y in turn will deposit the loan cheque in Bank C, which again post CRR and SLR lends money to Customer Z. And the cycle continues. So Rs 100 get converted into Rs100 + Rs75 + Rs60 and so on. This is known as money multiplier effect.

So when FED or RBI say that they are infusing XXX million in the economy, the effect of that will be not XXX million but XXX million into the money multiplier effect. The central banks always take this into consideration while infusing the funds into the system. For if they infuse the amount in absolute requirements, the system will have excess liquidity. And that will lead to inflation.

Therefore my take is that as of now there is enough liquidity in the system. However, it will take some time for the same to show its effect. The fact is that its lack of confidence on the part of the general population that is delaying the economic recovery. The morale of a common man takes long time to build up, once broken. So every one is scared of spending now, and thinks that the future is bleak. Only when the future will look bright will the mass loose its purse's strings. Till then the slump will continue.

And might be, just might be the American consumers are becoming smarter and avoiding unwanted expenditure. If that is the case, then the recovery will take more time.

1 comment:

arun said...

Good one bro ...Just a small doubt ...What are the ways in which money is infused into the system except for reducing the crr and slr...