The money multiplier in an economy increases with which one of the following?
Contents20
- AIncrease in the Cash Reserve Ratio in the banks
- BIncrease in the Statutory Liquidity Ratio in the banks
- CIncrease in the banking habit of the people
- DIncrease in the population of the country
Show answer
Answer: (C) Increase in the banking habit of the people
The money multiplier shows how much total money the banking system creates from an initial deposit.
Formula: Money Multiplier = 1/CRR.
Example: If CRR = 20% and someone deposits Rs 100, the bank keeps Rs 20 as reserve and lends Rs 80.
That Rs 80 gets deposited again, the bank keeps Rs 16 and lends Rs 64.
This continues until total deposits reach Rs 500 (100 x 1/0.20 = 500).
Option (a) is wrong: Higher CRR means banks must keep more reserves, less lending, lower multiplier.
Option (b) is wrong: Higher SLR also means banks keep more in liquid assets, less lending, lower multiplier.
Option (c) is correct: When more people use banks (higher banking habit), less cash stays idle in people's pockets.
More money enters the banking system, the cash-deposit ratio falls, and the multiplier increases.
Option (d) is wrong: Just increasing population does not increase the multiplier — what matters is whether people actually use banks.
Answer: (c).
The money multiplier determines how much total money supply the banking system can create from reserves, directly affecting liquidity in the economy.
RBI frequently adjusts CRR and SLR as monetary policy tools, making the relationship between these ratios and money multiplier a recurring exam concept.
The question tests understanding of the complete money multiplier formula which includes both reserve ratios and behavioral factors like cash-deposit ratio.
Money Multiplier Mechanism
Indian Economy money multiplier
Money Multiplier: Formula, Mechanism & UPSC Traps
Money Multiplier = 1/CRR - shows how banks create money from deposits
Higher CRR or SLR reduces the multiplier by forcing banks to hold more reserves
Increased banking habit raises the multiplier by reducing cash-deposit ratio
Population increase alone does not affect the multiplier
What is Money Multiplier
The money multiplier shows how much total money the banking system creates from an initial deposit through repeated lending. It works because banks operate under fractional reserve banking - they keep only a fraction of deposits as reserves and lend out the rest.
How Credit Creation Works
%%{init: {"flowchart": {"wrappingWidth": 460}}}%%
flowchart TD
s1["`**Initial Deposit**
Customer deposits **₹100** in Bank A`"]
s2["`**Reserve Requirement**
Bank keeps **₹20** as CRR (assuming 20% CRR)`"]
s3["`**Lending**
Bank lends out **₹80** to another customer`"]
s4["`**Re-deposit**
Borrower spends ₹80, recipient deposits it in Bank B`"]
s5["`**Cycle Repeats**
Bank B keeps **₹16** as CRR, lends **₹64**`"]
s6["`**Final Result**
Total deposits reach **₹500** (100 × 1/0.20)`"]
s1 --> s2
s2 --> s3
s3 --> s4
s4 --> s5
s5 --> s6Factors Affecting Money Multiplier
Factor | Change | Effect on Multiplier | Reason |
|---|---|---|---|
CRR | Increases | Decreases | Banks hold more reserves, lend less |
SLR | Increases | Decreases | Banks keep more in liquid assets, lend less |
Banking Habit | Increases | Increases | Less cash hoarding, more money in banking system |
Population | Increases | No direct effect | Multiplier depends on banking behavior, not population size |
Why Option C is Correct
When banking habit increases, people deposit more money instead of keeping cash at home. This reduces the cash-deposit ratio in the economy. More money enters the formal banking system, allowing banks to create more credit through the multiplier process.
Trap: CRR and SLR both sound like they help banks, but they actually reduce the money multiplier
Trap: Population increase seems logical, but multiplier depends on banking behavior, not just number of people
Confusion: Students mix up money multiplier with velocity of money - they are different concepts
Formula trap: Money Multiplier = 1/CRR, not CRR itself
Cash Reserve Ratio (CRR)
Indian Economy Cash Reserve Ratio
Cash Reserve Ratio: RBI's Primary Monetary Tool
CRR is the percentage of deposits banks must keep with RBI as reserves
Current CRR in India is 4% (as of recent years)
RBI increases CRR to reduce money supply and control inflation
No interest paid by RBI on CRR deposits
Definition & Purpose
Cash Reserve Ratio (CRR) is the minimum percentage of Net Demand and Time Liabilities (NDTL) that commercial banks must maintain as deposits with the Reserve Bank of India. It is RBI's most powerful tool to control money supply in the economy.
Key Features
Statutory requirement - banks cannot lend this portion of deposits
Maintained daily - banks must meet CRR requirement every day
Applies to all banks - scheduled commercial banks, cooperative banks, RRBs
Direct impact on liquidity - immediate effect on lending capacity
CRR vs Other Reserve Requirements
Reserve Type | Where Maintained | Interest Paid | Primary Purpose |
|---|---|---|---|
CRR | With RBI | No | Control money supply |
SLR | Bank's own vault | Yes (on investments) | Ensure liquidity safety |
Bank Rate | N/A (lending rate) | N/A | Signal monetary policy stance |
Impact on Money Multiplier
When RBI increases CRR, banks have less money available for lending. This directly reduces the money multiplier (1/CRR). For example, if CRR rises from 4% to 5%, the multiplier falls from 25 to 20, reducing credit creation capacity.
Trap: Higher CRR reduces money multiplier, not increases it
Confusion: CRR deposits earn no interest, unlike SLR investments
Mix-up: CRR is maintained with RBI, SLR is maintained by banks themselves
Statutory Liquidity Ratio (SLR)
Indian Economy Statutory Liquidity Ratio
Statutory Liquidity Ratio: Bank's Liquidity Safety Net
SLR is the percentage of deposits banks must keep in liquid assets like government securities
Current SLR in India is 18% (as of recent years)
Banks maintain SLR themselves - not with RBI like CRR
SLR investments earn interest, unlike CRR deposits
Definition & Components
Statutory Liquidity Ratio (SLR) is the minimum percentage of Net Demand and Time Liabilities (NDTL) that banks must maintain in liquid assets. Unlike CRR, banks keep SLR with themselves, not with RBI.
SLR Eligible Assets
# SLR Assets
## Cash
- Cash in hand
- Current account with RBI
## Government Securities
- Central govt bonds
- State govt securities
- Treasury bills
## Approved Securities
- RBI approved instruments
- Gold (valued at market price)Dual Purpose of SLR
Liquidity management - ensures banks have readily convertible assets during crisis
Government financing - creates captive market for government securities
Monetary control - reduces banks' lending capacity when increased
Prudential regulation - maintains banking system stability
Effect on Money Supply
When RBI increases SLR, banks must lock up more funds in government securities and liquid assets. This reduces their lending capacity, similar to CRR increase, thereby lowering the money multiplier and controlling inflation.
Key difference: SLR is maintained by banks themselves, CRR is maintained with RBI
Trap: Higher SLR reduces money multiplier by restricting lending capacity
Income: SLR assets earn interest (govt securities), CRR deposits earn nothing
Flexibility: Banks can trade SLR securities in emergency, but cannot touch CRR
Banking Habit & Financial Inclusion
Indian Economy banking habit
Banking Habit: From Cash Economy to Formal Banking
Banking habit means people preferring bank deposits over cash hoarding
Improved banking habit increases money multiplier by raising bank deposits
Reduces cash-deposit ratio in the economy
Jan Dhan Yojana and UPI have improved India's banking habit significantly
What is Banking Habit
Banking habit refers to people's tendency to use formal banking services - depositing money in banks, using digital payments, and avoiding cash hoarding. Higher banking habit means more money flows through the formal banking system rather than staying as idle cash.
How Banking Habit Affects Money Supply
%%{init: {"flowchart": {"wrappingWidth": 460}}}%%
flowchart TD
s1["`**Improved Banking Habit**
People deposit more money instead of keeping cash at home`"]
s2["`**Higher Bank Deposits**
More funds flow into the formal banking system`"]
s3["`**Lower Cash-Deposit Ratio**
Less money remains outside banking system`"]
s4["`**Increased Lending Capacity**
Banks have more deposits to lend out`"]
s5["`**Higher Money Multiplier**
Each rupee of deposit creates more credit in the economy`"]
s1 --> s2
s2 --> s3
s3 --> s4
s4 --> s5India's Financial Inclusion Initiatives
Initiative | Launch Year | Key Feature | Impact on Banking Habit |
|---|---|---|---|
Jan Dhan Yojana | 2014 | Zero balance accounts | Brought 45+ crore new accounts |
UPI (Unified Payments Interface) | 2016 | Instant digital payments | 12+ billion transactions monthly |
Aadhaar-enabled payments | 2017 | Biometric authentication | Banking access in remote areas |
RuPay cards | 2012 | Domestic card network | Reduced dependence on cash |
Factors Improving Banking Habit
Digital payment infrastructure - UPI, mobile banking, internet banking
Financial literacy programs - awareness about banking benefits
Government policy - Direct Benefit Transfer (DBT) encouraging bank accounts
Convenience factors - ATM networks, banking correspondents in villages
Core concept: Banking habit affects money multiplier, not just financial inclusion
Mechanism: Works by reducing cash-deposit ratio, not by creating new money
Population trap: More people ≠ higher multiplier; what matters is their banking behavior