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CA Foundation · Business Economics · Money Market

In a simple model, the public holds currency equal to 20% of deposits (c = 0.20) and banks hold reserves equal to 10% of deposits (r = 0.10). Using the multiplier m = (1 + c)/(c + r), what is the money multiplier, and what is the effect on it if the public's currency ratio rises to 0.30, with r unchanged?

The multiplier is 4 initially, since 1.20 divided by 0.30 equals 4. When the currency ratio rises to 0.30, it becomes 1.30 divided by 0.40, which is 3.25. More cash held by the public leaks from banks, so the multiplier falls.

  1. AMultiplier is 4, and it falls to 3.25Correct
  2. BMultiplier is 4, and it rises to 4.5
  3. CMultiplier is 3.33, and it falls to 3
  4. DMultiplier is 5, and it falls to 3.25

Explanation

Initially m = 1.20/0.30 = 4. With c = 0.30, m = 1.30/0.40 = 3.25. A higher currency ratio means more cash leaks out of the banking system, lowering the multiplier. Option D uses 1/r-type reasoning of 1/(0.2) = 5, ignoring the extra currency in the numerator.

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