Explain the Mechanism Behind the Money Multiplier. How Can the Monetary Authorities Influence Its Size and the Supply of Money?

Topics: Fractional-reserve banking, Monetary policy, Central bank Pages: 2 (645 words) Published: November 13, 2011
This essay will explain and illustrates the key mechanism behind the money multiplier and explore how monetary authorities can influence its size and affect the money supply in the economy. Firstly, an introduction on money measure will be presented. Secondly, the mechanism behind money multiplier will be presented by using equations to explain the cyclical changes in the multiple factor. Thirdly, the examination of the money multiplier in the current economic climate will be put forward. Fourthly, an explanation on the open market operation, discount window and the reserve ratio will be presented to convey the influence in the size of money supply. Finally, this essay will conclude with an overview of the essay.

According to Miller & VanHoose (1997) states distinctive measures can determine the money supply (M) through monetary aggregates, M2 and M4. The money measure M2 is the sum of deposit within retail bank and building societies plus currency held by household’ (Thomas, 2010). This can be expressed as:

M4 provides a broader measure of money. This includes deposits of wholesale banks, WD, plus certificate deposit, C and additional M2 (Thomas, 2010). This can be expressed as:
These money measures above indicate the level of liquidity held in the money supply, however the broader the measure, the less liquid it holds. The interaction between the Bank of England, Household and commercial bank and the behaviour defines money supply in form of currency deposit ratio and the reserve ratio (Thomas, 2010). The money supply can be expressed as: M = CU = D

The money multiplier holds a ‘mathematical relationship between the monetary base and the money supply of an economy’. The monetary base/high powered money ‘is the sum of currency in circulation plus reserves in the banking system’ (Howell & Bain, 2008).The money multiplier (mm) can be expressed as:

It explains the cyclical process in the amount of cash generated by the commercial banks (Business...
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