Money multiplier

Also called: Credit multiplier · Topic: Banking, Credit Creation and Monetary Policy · NCERT: Class 12, Ch 3 "Money and Banking"

Meaning

The money multiplier (also called the credit multiplier) is the number of rupees of money supply that come from every one rupee of high-powered money (reserve money, or M0), the money the RBI itself issues.

• Formula: Money supply = m × H, so m = Money supply ÷ H
• Simple model: m = 1/CRR. With a CRR of 20%, m = 1/0.2 = 5.
• Fuller formula (NCERT): m = (1 + cdr)/(cdr + rdr)

It matters because it shows how banks turn a small base of RBI money into a much larger stock of money held by the public. It also shows why the RBI controls money supply only partly.

Explanation

How the multiplier works: credit creation

• Fractional-reserve banking. A bank keeps only a part (fraction) of its deposits as reserves and lends the rest.
• Bank reserves = vault cash (cash in the bank's own safe) + the bank's deposits with the central bank. Reserves are not lent.
• Credit creation:
• A bank lends out part of a deposit.
• The borrower spends the money, and it comes back into a bank as a new deposit.
• That new deposit is lent again, after keeping a reserve.

• In the end, total deposits become a multiple of the reserves.

• Worked example (CRR = 20%):

Round	Deposits (₹)	Required reserve (₹)	Loan (₹)
1	100	20	80
2	180	36	64
Last	500	100	400 (total)

• Why ₹500? 100 + 80 + 64 + 51.2 + … is a geometric series with ratio r = 1 − 0.2 = 0.8.
• Sum = 100 × 1/(1 − 0.8) = 100 × 5 = ₹500.
• So m = 500 ÷ 100 = 5 = 1/CRR.

The fuller formula and its two ratios

• Currency deposit ratio (cdr) = currency held by the public ÷ the public's bank deposits.
• It shows how much people prefer to hold cash.

• Cash kept at home does not come back to banks, so it cannot be lent again.

• Reserve deposit ratio (rdr) = the share of deposits that banks keep as reserves.

• It includes the reserves the law requires (CRR) plus any extra reserves banks choose to keep.

• Formula: m = (1 + cdr)/(cdr + rdr)

• Worked example: cdr = 0.25, rdr = 0.20.
• m = 1.25/0.45 ≈ 2.8.

• This is well below the simple answer of 5, because part of the money stays outside banks as cash.

• Special case: if cdr = 0 (nobody holds cash), m = 1/rdr. This is the simple 1/CRR formula.

What makes the multiplier rise or fall

• Higher CRR means a smaller multiplier.
• If CRR rises from 20% to 25%, m falls from 5 to 4.
• Maximum deposits fall from ₹500 to ₹400. Maximum loans fall from ₹400 to ₹300.

• Banks must call back (recall) loans of ₹100, so money supply shrinks.

• Lower cdr means a bigger multiplier.

• People keep more money in banks and less as cash.

• More money comes back to be lent again, so m rises.

• Extra reserves held by banks (higher rdr) mean a smaller multiplier.

• Weak demand for loans means a smaller multiplier in practice.
• The formula gives the maximum.
• Banks cannot lend if firms and households do not want to borrow.

In India

• The RBI supplies H, and banks multiply it.
• Only the RBI can create high-powered money (M0).
• M0 = currency in circulation + bankers' deposits with RBI + other deposits with RBI.

• Sources of M0: RBI's net credit to government, RBI's credit to banks (for example, repo loans) and net foreign exchange assets.

• CRR is the legal lever. CRR is the average daily balance a bank must keep with the Reserve Bank, as a per cent of its net demand and time liabilities (NDTL), which roughly means the bank's deposits and similar liabilities to the public [2].

• CRR was cut to 4.0% of NDTL in December 2024 [5].

• It now stands at 3.00% [3].

• The actual multiplier (2024-25):

• m = M3 ₹272.87 lakh crore ÷ M0 ₹48.3 lakh crore ≈ 5.6.

• M3 is broad money: M1 + net time deposits of banks.

• Why not 33?

• At a 3% CRR, 1/CRR ≈ 33. But the real m is only about 5–6.
• The public holds a lot of cash, and banks keep vault cash above the CRR.
• Check with the fuller formula (approximate, 2024-25): cdr ≈ 0.15 and rdr ≈ 0.046, so m ≈ 1.15/(0.15 + 0.046) ≈ 5.8. This is close to 5.6.

• So the fuller formula describes India better.

• How the RBI measures it. The RBI has compiled monetary statistics since July 1935. It works out M3 with a balance-sheet approach that combines the balance sheets of the RBI and the banks [4].

Don't confuse with

• High-powered money (M0): this is the base (H) that the RBI issues. The money multiplier is the ratio (M ÷ H) showing how many times banks enlarge that base.
• Investment multiplier (Keynesian): this links a change in investment to a change in income or output, and it depends on the marginal propensity to consume. The money multiplier links reserve money to money supply, and it depends on CRR, cdr and rdr.
• CRR vs SLR: only CRR (cash kept with the RBI, earning no interest) enters the simple multiplier formula. SLR is kept by the bank itself in safe liquid assets such as unencumbered (not already pledged) government securities, cash and gold, and it earns interest [2].
• Simple vs actual multiplier: 1/CRR is the maximum in a world where nobody holds cash. The actual m (≈ 5.6 in 2024-25) is much lower because of cdr and extra reserves.

Prelims Hooks

• Simple multiplier = 1/CRR. Fuller multiplier m = (1 + cdr)/(cdr + rdr). If cdr falls, m rises. If CRR or rdr rises, m falls.
• Money supply = m × H, where H = high-powered money = M0 = reserve money = monetary base. India 2024-25: m ≈ 5.6 (M3 ₹272.87 lakh crore ÷ M0 ₹48.3 lakh crore).
• CRR is kept with the RBI as a % of NDTL [2]. Trap: "CRR balances can be held in government securities" is false. Government securities count towards SLR.
• Current CRR = 3.00% [3]. It was cut to 4.0% in December 2024 [5].
• Banks cannot create H. Only the RBI can. When the RBI buys forex or G-secs, H rises, and with a given m, money supply rises.
• NCERT slip: the Class 12 appendix sums the series with r = 0.4 and gets 5/3. For a 20% CRR, the correct ratio is r = 0.8, which gives 1/(1 − 0.8) = 5.

Mains Points

• The RBI controls money supply only partly.
• The RBI controls H and the CRR.
• But m also depends on the public's cash habit (cdr) and on banks' willingness to lend and borrowers' demand for loans.

• So a CRR cut (4% in December 2024 [5] → 3% [3]) frees money for banks, but credit grows only if people want loans. This explains why RBI policy can pass through weakly to the economy.

• Financial inclusion makes monetary policy stronger.

• Jan Dhan accounts and digital payments lower cdr.
• A lower cdr raises m, and more money stays inside banks, where RBI signals can reach it.

• Demonetisation (2016-17) showed the reverse effect on currency with the public.

• The fractional-reserve trade-off.

• A low reserve ratio gives a high multiplier, which means more lending and growth.
• But it raises the risk of a bank run (many depositors withdrawing at once).
• So credit creation needs prudential rules (CRR, SLR, capital norms), a lender of last resort (the RBI) and deposit insurance (DICGC). This point suits GS-III answers on financial stability.

Related concepts

• Credit creation
• Bank balance sheet
• Bank reserves
• Currency deposit ratio
• Reserve deposit ratio
• Bank run
• High-powered money
• Currency in circulation
• Money supply
• M1

Read more

• Credit creation, high-powered money and the money supply