Calculating Money Creation and the Money Multiplier

1. The Core Calculation: Finding Total Deposits and Loans

This is the most fundamental type of problem. You are typically given the initial deposit and the LRR and asked to find the total deposits created and the total loans disbursed by the banking system.

Let's walk through the steps for a typical problem:

• Problem: Assume the initial deposit in the banking system is ₹500 crores and the LRR is 25%. Calculate the total deposits and total loans created.

• Step 1: Calculate the Money Multiplier (K).

  • LRR = 25% or 0.25
  • $K=\frac{1}{\text{LRR}}=\frac{1}{0.25}=4$
  • This means the initial deposit will be multiplied four times.

• Step 2: Calculate Total Deposits.

  • $\text{Total Deposits}=\text{Initial Deposit}\times K$
  • $\text{Total Deposits}=₹500\text{ crores}\times 4=₹2,000\text{ crores}$

• Step 3: Calculate Total Loans.

  • Remember, the banking system must keep the initial deposit amount as total reserves. The rest is given out as loans.
  • $\text{Total Loans}=\text{Total Deposits}-\text{Initial Deposit}$
  • $\text{Total Loans}=₹2,000\text{ crores}-₹500\text{ crores}=₹1,500\text{ crores}$

The following video solves this exact problem. Watching the instructor work through it will reinforce the method.

2. Working Backwards: Finding the LRR

Examiners often reverse the problem. They might give you the initial and total deposits and ask you to calculate the LRR. This requires you to rearrange the formulas.

• Problem: If an initial deposit of ₹12,500 leads to a total deposit creation of ₹50,000, what is the Legal Reserve Ratio (LRR)?

• Step 1: Calculate the Money Multiplier (K).

  • $K=\frac{\text{Total Deposits}}{\text{Initial Deposit}}$
  • $K=\frac{₹50,000}{₹12,500}=4$

• Step 2: Calculate the LRR from the multiplier.

  • We know $K=\frac{1}{\text{LRR}}$, so we can rearrange this to $\text{LRR}=\frac{1}{K}$.
  • $\text{LRR}=\frac{1}{4}=0.25$
  • Converting this to a percentage, the LRR is 25%.

This next video demonstrates this exact calculation.

3. Finding the Initial Deposit

Here's another variation. You are given the total deposits and the LRR, and you need to find the initial deposit that started the whole process.

4. Practice with Table-Based Questions

Sometimes, questions are presented in the form of an incomplete table showing the rounds of credit creation. This tests your understanding of the process itself.

The key is to remember that in each round:

• The "Deposit" is the "Loan" from the previous round.
• The deposit is split into "Reserves" (based on LRR) and "Loans".
• The totals at the bottom of the table can be verified using the money multiplier formula.

Let's watch an example of how to solve a fill-in-the-blanks table problem.

5. Analysing Policy Changes: Impact of a Change in LRR

A more advanced question might ask you to calculate and explain the effect of a change in the LRR on the money supply. This combines your numerical skills with your conceptual understanding.

• Scenario: Suppose initial deposits are ₹1,000 and the LRR is increased from 20% to 25%. Calculate and explain the impact on credit creation.

Analysis:

• Case 1 (LRR = 20%):
  • $K=1/0.20=5$
  • Total Deposits = $₹1,000\times 5=₹5,000$
• Case 2 (LRR = 25%):
  • $K=1/0.25=4$
  • Total Deposits = $₹1,000\times 4=₹4,000$

Conclusion/Explanation: Increasing the LRR from 20% to 25% reduces the money multiplier from 5 to 4. This decreases the banks' capacity to create credit, causing the total money supply to fall from ₹5,000 to ₹4,000. This is a tool the central bank can use to control inflation.

The following video provides a detailed numerical and theoretical explanation of this exact type of scenario.

Conclusion

Today, we've focused entirely on practice, tackling the money multiplier numericals from several different angles. Your ability to work with numbers in accounting is a strong asset here; the key is to apply the specific economic logic and formulas correctly.

Key Takeaways:

• You can solve for any of the three main variables (Initial Deposit, Total Deposits, LRR) as long as you know the other two.
• The core formulas are $K=1/\text{LRR}$ and $\text{Total Deposits}=\text{Initial Deposit}\times K$.
• Remember that Total Loans = Total Deposits - Initial Deposit.
• A higher LRR leads to a lower money multiplier and less credit creation, while a lower LRR does the opposite.

In our next lesson, we will broaden our scope to look at the tools the Reserve Bank of India uses to manage the money supply. You've just seen one of them in action: changing the Legal Reserve Ratio. We will explore this and other instruments of monetary policy in more detail.