What Is Credit Multiplier, Economics
Credit multiplier is another useful concept used in the analysis of money supply. Let us first make a distinction between the between the deposit multiplier and the credit multiplier. Deposit multiplier, (dm) is the ratio of total deposit creation (?TD) to the primary deposits with banks (?D), that is, dm = ?TD/ ?D. Similarly, credit multiplier Can be defined as the ratio of additional credit creation (?CC) to the total cash reserves (?R). That is credit multiplier (cm) can be measured as:
Credit multiplier (cm) = ?CC/?R
Total credit income creation (?CC) by the banks = $ 400 thousand, and total reserves = $ 100 thousand. Thus the credit multiplier can be obtained as
cm = ?CC/?R =400,000/100,000 = 4
The total credit creation (?CC) by the commercial banks can be obtained by subtracting the change in cash reserves (?R) from the total deposit creation (?TD). That is
?CC = ?TD – ?R
= 500,000 – 100,000
By substituting ?TD – ?R for ?CC credit multiplier (cm) can be expressed as
cm = (?TD – ?R)/?R
The formula for credit multiplier (cm) can be derived following the formula for deposit (dm). Thus equation can be written as
cm = (1 – r)/r
It is important to note here that the forgoing analysis of deposit and credit multiplier process has been carried out in the framework of a static model with highly restrictive assumptions that deposit or credit multiplier process does not affect currency holding and time deposits by the people. This analysis will, therefore, not apply if assumptions are relaxed to make model realistic.
In this section we will discuss briefly the multipliers associated with government’s fiscal operations, called fiscal operations. Given our limited purpose here, we consider only the main fiscal operations of the government.
(i) government expenditure (including transfer payments)
(ii) Taxation of incomes.
Government’s fiscal operations affect the equilibrium level of national income depending on the multiplier effects of fiscal operations. Government expenditure (with no taxation) increases the equilibrium level of national income. The overall effect of the government expenditure on the national income depends on the value of government expenditure multiplier. On the other hand, taxation (with no government expenditure) causes a reduction in the national income. The overall effect of taxation depends on the tax multiplier. In practice, however both the fiscal operations (government spending and taxation) go side by side. If the government adopts a balanced budget policy, it spends only as much it taxes. In that case, the overall effect of the government’s fiscal operations on the national income depends on the combined effect of expenditure and tax multipliers. In this section we describe the method of working out the expenditure multiplier, tax multiplier and the balanced budget multiplier.
Posted by Aman | Posted Date: 11/14/2011 4:11:47 AM