RBI releases a lot of data on monetary aggregates on a weekly basis. Though, analysing monetary data is not in fashion anymore, it does throw long term trends. Take the case of money multiplier (MM). It is a common measure mentioned in most text books. When it comes to practice or seeing research on monetary policy, you hardly find a mention. With this crisis we expect renewed focus on monetary variables etc. So, I thought to describe it a bit.
MM is the amount of money the banking system generates with each rupee of reserves. It works like this.
- Say you deposit 100 Rs with a bank. Banks are required to maintain a percentage of deposits collected as cash reserves with central bank.
- The central bank imposes this reserve on the bank to manage liquidity situation in an economy. In India we call this Cash reserve ratio (CRR).
- So let us assume CRR is 10%. Then Bank deposits Rs 10 with RBI and lend the Rs 90 to another customer X.
- X takes the loan and say buys a machinery from Y. Y takes the payment and deposits the money in his bank.
- The bank again gives the money for credit after netting out the reserves. And the cycle goes on this manner. So 100 Rs of deposit with a bank leads to multiplies of the same amount. This is called money multiplier.
Now how to measure it?
- It can be measured as: (1+c)/(c+r), where, c is currency-deposit ratio and r is reserve requirement ratio (CRR in India’s case).
- Currency is currency held by the public for transactions and is given by RBI on a fortnight basis.
- Deposits are measured as term deposits at banks and is also given by RBI on a fortnight basis.
- Both currency and term deposits form part of the money supply.
- We take the ratio of both as people keep part of money as currency and part as deposits. The relation between currency, term deposit and reserve ration gives us the money multiplier. A reduction in r leads to an increase in the money multiplier and vice versa.
The below graph shows the money multiplier in India from Apr-2008 to 9-April -10.
Between April 08-Aug-08, multiplier declined from 4.3 to 4.1 levels as RBI increased CRR from 7.5% to 9%. This was a time of high liquidity and inflation was increasing. And RBI was tightening the policy. RBI increased CRR multiple times.
In Sep-08, the global crisis hit Indian economy and RBI started easing the policy rates sharply. In a series of steps, CRR was lowered to 5% by 30-Jan 09. This led to increase in money multiplier which increased to 4.8 levels by Apr-09. As economy picked up from Apr-09 levels, multiplier increased further to 4.9 levels in Oct-09.
As economy had stabilised, RBI started increasing policy rates. It raised CRR in Jan-10 policy to 5.75% in two stages. As a result, we start to see decline in multiplier. It was at 4.66 on 9-Apr-10. AS we expect CRR to rise further, MM should decline over the years.
If we compare this with other developed economies, we can see the difference. In US, UK etc money multiplier failed to pick up despite central banks easing policy. So they had to resort to unconventional monetary policy to increase flow of money in the economy.
Let’s hope to read more research on monetary variables in other economies after this crisis.