The Problem: The Confusion of "New Money":
Most students think that only the Central Bank (NRB/RBI) can create money. They wonder: "If the bank only printed 100 rupees, how can the total deposits in the country be 1,000 rupees?" The answer is Commercial Bank Lending.
The Step-by-Step Multiplier Process:
Imagine the Central Bank sets the Required Reserve Ratio (RRR) at 10%. This means for every deposit, the bank must keep 10% in the vault and can lend the remaining 90%.
Step A: You deposit Rs. 100 in Bank 1.
Step B: Person X buys a book. The Bookstore owner takes that Rs. 90 and deposits it into Bank 2.
Step C: Person Y buys groceries. The Grocer deposits Rs. 81 into Bank 3.
Result: Even though there was only one physical 100-rupee note, the "Total Money Supply" (the sum of all deposits) keeps growing!
The Easy Math:
Instead of adding up thousands of steps, we use the Money Multiplier formula:
Lesson: The higher the reserve ratio, the lower the money multiplier. This is why Central Banks increase the reserve ratio to fight Inflation—it stops banks from creating too much "magic money."
The Money Multiplier in Action (10% Reserve Ratio):
This table shows how an initial deposit of Rs. 1,000 expands across the banking system.
| Step | Bank | Deposit Received | Kept as Reserve (10%) | Amount Lent Out (New Money) |
| 1 | Bank A | Rs. 1,000 | Rs. 100 | Rs. 900 |
| 2 | Bank B | Rs. 900 | Rs. 90 | Rs. 810 |
| 3 | Bank C | Rs. 810 | Rs. 81 | Rs. 729 |
| ... | ... | ... | ... | ... |
| Total | All Banks | Rs. 10,000 | Rs. 1,000 | Rs. 9,000 |
Why does this matter for your Exams?
In a competitive exam (like Bank Officer or MA Economics), you might get a "Problem" like this:
Question: "If the Central Bank wants to reduce the money supply, should it increase or decrease the CRR (Cash Reserve Ratio)?"
Solution:
Increasing CRR means banks have less to lend.
Less lending means the Money Multiplier drops.
Therefore, the Money Supply decreases.
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