The multiplier effect describes how an increase in one economic activity leads to a much more significant increase in economic output. For example, in the banking system, money that gets deposited multiplies as it filters through the economy, going from depositor to borrower multiple times. As a result, the money supply will ultimately change by a multiple of that amount for any change in bank reserves.
Just think about a bicycle. On a bicycle, when you pedal with your feet, a minimal rotation leads to a much bigger turn of the wheels. So likewise, minimal changes in the banking system can lead to much more significant changes in the economy’s money supply.
Let’s look at the multiplier effect as it unfolds using an example.
If you have Rs 10 Lakhs and deposit it in a bank, then the banking reserve would go up by this Rs 10 Lakhs. Assuming a bank can lend 90% of this deposit after keeping the remaining amount in reserve with the central bank. Assuming Mr. A comes to the bank and requires Rs 9 Lakhs for some business activity. Mr. A gets the loan from the bank and uses the money to purchase some machinery from Mr. B. The machinery seller, Mr. B, deposits the money in his bank in another city. Assuming another borrower Mr. C, borrows Rs 8 as a car loan. The car dealer would get Rs 8 lakhs and use the money to meet expenses and deposit the balance money in his bank. This cycle of borrowing, deposits, and lending will continue and add to the overall economic activities of a country. In this process, a reserve amount would be created simultaneously with the country’s central bank.