Show the example on multiplier effect, Macroeconomics

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Q. Show the example on multiplier effect?

Emma makes a deposit:        

Emma has 1,000 in her mattress and decides to deposit it in K-bank. Deposit won't affect the money supply though K-bank now has 11,000 in deposits, 9,000 in loans and 2,000 in reserves.

K-bank lends money:  

With deposits equal to 11,000, K-bank wants reserves to be 1,100, not 2,000. Bank hence wants to lend 900, which is, 90% of the amount Emma deposited. Bank now lends 900 to Ashton.

Ashton borrows money:       

At the same instance K-bank lends 900 to Ashton, money supply increases by 900. Emma's decision to transfer 1,000 from mattress to bank has the effect of increasing the money supply by 900. There are 3 ways Ashton can use the funds borrowed from K-bank. He can withdraw the funds in cash as well as keep the cash, he can keep them in his account at K-bank or he can spend them (or a combination of all three).

Ashton withdraws the money:       

If Ashton withdraws the funds in cash, K-bank would have 11,000 in deposits, 9,900 in loans and 1,100 in reserves. So it will prefer not to lend any money till deposits increase.

Ashton keepsthe funds in his account:    

If Ashton decides to keep his funds with K-bank then the deposits will increase by 900 the same instant it lends Ashton the money. K-bank would now have 11,900 in deposits, 9,900 in loans and 2,000 in reserves. 

K-bank lendsmoneyagain:   

In the case where Ashton keeps his funds in his account at K-bank, bank will want to increase lending further. In the subsequent step, it will want to lend 90% of 900 or 810. When it lends 810, money supply would increase by 900 + 810 = 1,710 due to the deposit made by Emma. If the second borrower also decides to keep the funds in the bank, bank can lend money a third time. In third step it will lend 90% of 810 or 729. Note that amount in every step will be smaller and smaller and if you add them, you will always end up with a finite amount.

...andwe have a multipliereffect:   

If all or some of the borrowers keep borrowed funds in the bank, a deposit will produce an increase in the money supply that is larger than initial deposit and this is what we call multiplier effect. Remember that this effect isn't guaranteed - had Ashton withdrawn the borrowed funds in cash, he would have broken the chain and increase in money supply would have been equal to the deposit.

Ashton spends the money:    

We had a third possibility: Ashton may spend the borrowed funds. Let's say Ashton buys a stamp collection from Brittney for 900. If Brittney uses same bank as Ashton, funds will simply be transferred to Brittney's account. Though to K-bank, this makes no difference. K-bank will still want to increase its lending.

...will          not disturb the multiplier effect:    

If Brittney has a different bank, funds would be transferred from K-bank to Brittney's bank. In this scenario, K-bank would not be interested in lending any more money. Though, in this case, deposits have increased in Brittney's bank and multiplier effect continues in her bank. The only way the chain of multiplier effect may be broken is if someone withdraws funds in cash and keeps the cash (if cash is spent and it goes into an account -multiplier effect will take off again). If some of the funds are withdrawn, multiplier effect is weakened however not broken.


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