The RBI lowers the Cash Reserve Ratio (CRR) from 20 per cent to 10 per cent. Banks lend more, and investment in the economy rises by Rs 100 crore. The marginal propensity to consume (MPC) is 0.8. Other things remaining the same, which of the following is correct?
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → The money multiplier rises from 5 to 10, and equilibrium income rises by Rs 500 crore.
Given:
CRR falls from 20 per cent (0.2) to 10 per cent (0.1)
Rise in investment, ΔI = Rs 100 crore
Marginal propensity to consume, c = 0.8
The money multiplier is 1 / CRR. The investment multiplier is 1 / (1 − MPC).
Money multiplier before and after the cut:
\( \displaystyle \text{Before} = \frac{1}{0.2} = 5 \)
\( \displaystyle \text{After} = \frac{1}{0.1} = 10 \)
Investment multiplier and the rise in income:
\( \displaystyle \text{Investment multiplier} = \frac{1}{1 - 0.8} = \frac{1}{0.2} = 5 \)
\( \Delta Y = 5 \times 100 = \text{Rs } 500 \text{ crore} \)
MPC has no role in the money multiplier. It depends only on the CRR. In the same way, the CRR has no role in the investment multiplier.
This question uses Money and Banking and Determination of Income and Employment together.
NCERT (2026-27): 3.3.2 Limits to Credit Creation and Money Multiplier
“3.4 Policy Tools to Control Money Supply … It should be evident by now that if the Central bank changes the reserve ratio, this would lead to changes in lending by the banks which, in turn, would impact the deposits and hence, the money supply. …” Determination of Income and Employment: “4.3.2 Effect of an Autonomous Change in Aggregate Demand on Income and Output … 2. Change in investment: we have assumed that investment is autonomous. However, it just means that it does not depend on income. There are a number of variables other than income which can affect investment. One important factor is availability of credit: easy availability of credit encourages investment. …” “4.3.3 The Multiplier Mechanism … It was seen in the previous section that with a change in the autonomous expenditure of 10 units, the change in equilibrium income is equal to 50 units (from 250 to 300). … When income increases by 10, consumption expenditure goes up by (0.8)10, since people spend 0.8 (= mpc) fraction of their additional income on consumption. … The increment in equilibrium value of total output thus exceeds the initial increment in autonomous expenditure. The ratio of the total increment in equilibrium value of final goods output to the initial increment in autonomous expenditure is called the investment multiplier of the economy. Recalling that 10 and 0.8 represent the values of ΔI = ΔA and mpc, respectively, the expression for the multiplier can be explained as”
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