The money multiplier in an economy increases with which one of the following?
Contents15
- AIncrease in the cash reserve ratio
- BIncrease in the banking habit of the population
- CIncrease in the statutory liquidity ratio
- DIncrease in the population of the country
Show answer
Answer: (B) Increase in the banking habit of the population
The correct answer is (B) — Increase in the banking habit of the population.
The money multiplier shows how much the total money supply increases for every rupee of base money.
When more people use banks (higher banking habit), more money gets deposited, banks can lend more, and those loans become new deposits elsewhere — creating a multiplier effect.
Increasing CRR (A) or SLR (C) would REDUCE the multiplier because banks must keep more money in reserve.
Population increase alone (D) doesn't change the multiplier.
Tip: More people banking = more deposits = more lending = higher money multiplier.
The money multiplier determines how much total money supply increases when RBI injects one rupee of base money into the banking system.
Jan Dhan Yojana and digital payments push have increased banking penetration significantly, making the concept of banking habits affecting money supply practically relevant.
The question tests understanding that money multiplier depends on behavioral factors like banking habits, not just regulatory ratios like CRR and SLR.
Money Multiplier Concept
Indian Economy money multiplier
Money Multiplier: Formula, Mechanism & UPSC Applications
Quick Revision
Money multiplier = 1 ÷ (CRR + SLR + Currency-Deposit Ratio)
Higher banking habit reduces currency-deposit ratio → increases money multiplier
Higher CRR or SLR reduces money multiplier
Shows how ₹1 of base money creates multiple rupees in total money supply
What is Money Multiplier
The money multiplier measures how much the total money supply expands when the central bank injects ₹1 of base money into the banking system. It works through fractional reserve banking — banks keep only a fraction of deposits as reserves and lend out the rest.
Factors Affecting Money Multiplier
Factor | Increase Causes | Why | UPSC Trap |
|---|---|---|---|
Cash Reserve Ratio (CRR) | Multiplier decreases | Banks must keep more reserves, less lending | Students think more reserves = more multiplication |
Statutory Liquidity Ratio (SLR) | Multiplier decreases | Banks must buy more govt securities, less lending | Similar confusion as CRR |
Banking Habit | Multiplier increases | More deposits → lower currency-deposit ratio | Key to solving this PYQ |
Currency-Deposit Ratio | Multiplier decreases | People hold more cash outside banks | Counter-intuitive for students |
How Banking Habit Increases Multiplier
%%{init: {"flowchart": {"wrappingWidth": 460}}}%%
flowchart TD
s1["`**People develop banking habit**
More people deposit money instead of holding cash`"]
s2["`**Currency-deposit ratio falls**
Less cash outside banks, more in the banking system`"]
s3["`**Banks receive more deposits**
Higher deposit base available for lending`"]
s4["`**Banks can lend more**
After keeping CRR/SLR, more funds available for loans`"]
s5["`**Loans become new deposits**
Borrowers deposit loan money in other banks`"]
s6["`**Process repeats**
New deposits create more lending capacity`"]
s7["`**Money multiplier increases**
Same base money creates larger total money supply`"]
s1 --> s2
s2 --> s3
s3 --> s4
s4 --> s5
s5 --> s6
s6 --> s7Question Analysis
This PYQ tests the inverse relationship between currency-deposit ratio and money multiplier. When banking habit increases, people deposit more and hold less cash — reducing the currency-deposit ratio and increasing the multiplier. Options A and C are direct traps because students confuse 'more reserves' with 'more multiplication'.
Trap: Higher CRR means more money in banks, so multiplier increases — Wrong! Higher CRR reduces lending capacity
Trap: Population increase automatically increases multiplier — Wrong! Only if new people use banks (banking habit matters)
Trap: SLR increases bank assets, so multiplier increases — Wrong! SLR reduces lendable funds
Memory: Money multiplier formula has these in denominator — so increasing CRR/SLR/Currency ratio reduces multiplier
CRR & SLR Banking Reserves
Indian Economy cash reserve ratio statutory liquidity ratio
CRR vs SLR: Definitions, Current Rates & Monetary Impact
Current Status
CRR: Currently 4% (varies with RBI policy)
SLR: Currently 18% (minimum 18%, can be higher)
Both are RBI tools to control money supply and liquidity
Higher CRR/SLR = contractionary monetary policy
CRR vs SLR Comparison
Aspect | Cash Reserve Ratio (CRR) | Statutory Liquidity Ratio (SLR) |
|---|---|---|
Definition | % of deposits kept with RBI in cash | % of deposits in liquid assets (cash + govt securities) |
Where Kept | RBI account (cannot be used) | Bank's own vault (can be accessed) |
Liquidity | Zero liquidity for banks | High liquidity — can sell govt securities |
Interest Earned | No interest from RBI | Interest earned on govt securities |
Primary Purpose | Control money supply | Ensure bank solvency and govt borrowing |
Impact on Lending | Direct reduction in lendable funds | Indirect — diverts funds from private lending |
How They Affect Money Multiplier
Increasing CRR: Banks must park more money with RBI → less lending → lower money multiplier
Increasing SLR: Banks must buy more govt bonds → less private lending → lower money multiplier
RBI uses both during inflation to reduce money supply and credit growth
Legal minimums: CRR can be 0% minimum, SLR cannot go below 18%
Frequency: RBI reviews both rates in monetary policy meetings every 2 months
Trap: CRR money 'stays in banking system' so multiplier increases — Wrong! It's locked with RBI
Trap: SLR provides liquidity so multiplier increases — Wrong! It reduces lendable funds
Trap: Confusing CRR with repo rate — CRR is deposit ratio, repo is borrowing rate
Memory trick: Both CRR and SLR tie up bank money → less lending → lower multiplier
Currency-Deposit Ratio
Indian Economy banking habit population
Currency-Deposit Ratio: Impact on Money Multiplier & Banking Penetration
Key Relationships
Currency-Deposit Ratio = Cash with public ÷ Deposits with banks
Lower ratio = more banking habit = higher money multiplier
India's ratio is higher than developed countries due to cash preference
Digital payments and financial inclusion reduce this ratio
Banking Habit Connection
Banking habit refers to people's tendency to use banks for saving, payments, and transactions instead of holding physical cash. When banking habit increases, the currency-deposit ratio falls because more money flows into the banking system rather than staying as cash in people's hands.
Factors Affecting Currency-Deposit Ratio
Factor | Effect on Ratio | Impact on Money Multiplier | Examples |
|---|---|---|---|
Improved banking habit | Decreases | Increases | More people open bank accounts |
Digital payment adoption | Decreases | Increases | UPI, cards replace cash transactions |
Financial inclusion | Decreases | Increases | Jan Dhan accounts, rural banking |
Economic uncertainty | Increases | Decreases | People prefer cash during crisis |
Higher denomination notes | Increases | Decreases | Easier to hold large cash amounts |
Demonetization | Temporary decrease | Temporary increase | Forces money into banks initially |
India-Specific Context
Post-demonetization: Currency-deposit ratio fell sharply in 2016-17, then gradually recovered
COVID-19 impact: Digital payments surged, reducing cash preference among urban population
Rural vs urban: Rural areas still have higher currency-deposit ratios due to limited banking access
Policy focus: Government promotes Digital India and JAM trinity to reduce cash dependence
Seasonal pattern: Ratio increases during festivals and harvest seasons when cash demand rises
Trap: More population automatically means higher multiplier — Wrong! Depends on banking habits of new people
Trap: Currency-deposit ratio and money multiplier move in same direction — Wrong! They're inversely related
Trap: Demonetization permanently increased money multiplier — Wrong! Effect was temporary
Key insight: Population growth matters only if accompanied by improved banking penetration