Multiplier effect

Multiplier effect is the expansion of the quantity of money due to fractional reserve banking. When the reserve ratio is set higher, the ability of banks to loan money to its customers are reduced because of a tighter available cash in vault. This scenario creates a bottle neck in the flow of credit therefore less money in circulation. When the reserve ratio is reduced, freed reserves from the central bank allows banks to loan out more money to its customers. This condition allows people to access credit easier therefore, spending is increased. An increase in spending requires more goods to be produced therefore as per law of demand, prices increase with the flood of money being injected.

The merchant deposits the fund he received from you at another bank. Bank 2 puts 20% of that deposit into the central bank as reserve requirement. When Bank 2 opens a new loan account for somebody, money is again created.

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