Final answer:
The money multiplier is the ratio of the change in the quantity of money to the change in the quantity of the monetary base. It is calculated using the formula 1/reserve ratio and is a key component in how banks create the majority of money in an economy through lending.
Step-by-step explanation:
The money multiplier is the ratio of the change in the quantity of money to the change in the quantity of the monetary base. Specifically, it measures how much the money supply (e.g., M1 or M2) increases for a given increase in the monetary base. The monetary base includes reserves held at the bank and currency in circulation. The money multiplier is essential because it reflects the ability of banks to create money through lending and thereby expanding the overall money supply in the economy. By considering the reserve ratio, which is the fraction of deposits that banks wish to hold as reserves, one can calculate the money multiplier using the formula 1/reserve ratio. This process of banks making loans, people making deposits, and banks making more loans, creates the bulk of money in the economy, effectively 'multiplying' the initial deposits.