Money multiplier is really about credit out of “thin air”

According to traditional economics textbooks, the current monetary system amplifies the initial monetary injections of money. The popular story goes as follows: if the central bank injects $1 billion into the economy and banks have to hold 10% in reserve against their deposits the initial injection of $1 billion will become $10 billion i.e. money supply will expand by a multiple of 10. Note that in this example the central bank has actively initiated monetary pumping of $1 billion, which in turn banks have amplified to $10 billion.

Economists from the post-Keynesian school of economics (PK) have expressed doubt about the validity of this popular framework of thinking[1]. One of the advocates of this school, Bill Mitchell, in an article on his blog – Money Multiplier and other Myths – wrote that,

It (money multiplier) is also not even a slightly accurate depiction of the way banks operate in a modern monetary economy characterised by a fiat currency and a flexible exchange rate. In the present monetary framework, it is held the job of the central bank is to ensure that the level of cash in the money market is in tune with the interest rate target.

According to Mitchell,

The way banks actually operate is to seek to attract credit-worthy customers to which they can loan funds to and thereby make profit.

 

Furthermore, according to Mitchell,

So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.

The role of the central bank according to the PK’s in the modern banking system is of a balancing nature. For instance, if on a particular day the Government intake of cash exceeds outlays this leads to a deficiency of cash on the day. To prevent a scramble for cash in the money market and a subsequent increase in the overnight interest rate, the central bank must inject an appropriate amount of cash in order to keep the interest rate at the target. Note that the central bank here is performing a balancing act, or so it is held.

In this way of thinking it would appear that the central bank has nothing to do, at least directly, with an expansion in the money supply. (In fact most central bankers would agree with this). The key source of money expansion is commercial banks that via an expansion in lending set in motion an expansion in the money supply. (For PK economists’ commercial banks liabilities are seen as the primary money used by non-banks. The demand for loans plus the willingness of banks to lend determines the quantity of loans and thus of deposits created).

The supply of loans in this way of thinking is never independent of demand – banks supply loans only because someone is willing to borrow bank money by issuing an IOU to a bank. To conclude then, according to this way of thinking the driving force of bank credit expansion and thus money supply expansion is the increase in the demand for loans and not the central bank as the money multiplier model presents. On this way of thinking banks will always oblige to the demand of a good quality borrower.

 

Is the money multiplier a myth or reality? 

It does seem that if one were to accept the PK story then it is valid to suggest that the multiplier is just a myth. However, is it really a myth?

Let us say that for whatever reason banks are experiencing an increase in the demand for loans. Also, let us assume that the supply of loanable funds is unchanged. According to PK banks will oblige this increase. The demand deposit accounts of the new borrowers will now increase.

Obviously, the new deposits are likely to be employed in various transactions. After some time elapse banks will be required to clear their checks and this is where problems might occur.

Some banks will find that to clear checks they are forced either to sell assets or are forced to borrow the money from other banks (remember the pool of loanable funds stays unchanged). Obviously, all this will put an upward pressure on money market interest rates and in turn on the entire interest rate structure.

Higher interest rates in turn are likely to force marginal borrowers out of the “game”. Also, some banks could go belly up as a result of not being able to honor their checks. To prevent all this, the central bank will be forced to pump money. Once the central bank pumps money to maintain a given interest rate target (or if required to lower further the target to prevent banks bankruptcies) it in fact gives the green light to the money multiplier process (the creation of credit out of “thin air”).

As we can see, the subject matter of multiplier is the creation of credit out of “thin air”. An example will provide the meaning of credit out of “thin air”.

For instance, Tom exercises his demand for money by holding some of his money in his pocket and keeps $1000 in Bank X’s demand deposit. By placing $1000 in a demand deposit, he maintains his total claim on the $1000. Now, Bank X helps itself and takes $100 from Tom’s deposit and lends this $100 to Mark. Lending to Mark means that Bank X opens a demand deposit to Mark of $100, which Mark now can use in paying his bills. Note that Tom has never relinquished his ownership over the $100 that was taken from his demand deposit and loaned to Mark. As a result of this lending we now have $1,100 which is comprised of the original $1000 plus $100 of Mark’s demand deposit. The money stock has increased by $100. Furthermore, if both Tom and Mark would attempt to withdraw their money from Bank X the Bank will be in trouble since it only has $1000 and will be short of $100.

Once banks have the confidence that there is a helping hand from the central bank, they will supply loans in accordance with the demand for loans. (Note the central bank’s daily money market operation makes sure that there is enough liquidity to prevent banks from bankrupting each other during the clearings of checks).

Observe that the conceptual outcome as depicted by the multiplier model remains intact here. The only difference is that banks initiate the lending process, which is then accommodated by the central bank. In both cases we have the creation of credit out of “thin air”.

The so-called multiplier or the sustained expansion of credit out of “thin air” cannot emerge in its own right without the support from the central bank. If the multiplier process requires the support of the central bank then one can infer that in a free market without the central bank the likelihood of such a process emerging is not very high.

In a free market if a particular bank tries to expand credit without funding from a genuine lender i.e. practicing fractional reserve banking, it runs the risk of not being able to honor its checks, which raises the risk of bankruptcy.

Also, it must be realised that in a free market we should expect that the likelihood of a bank being “caught” practicing fractional reserve banking is going to be high, as there are many competitive banks. As the number of banks rises and the number of clients per bank declines, the chances that clients will spend money on the goods of individuals that are banking with other banks will increase. This in turn raises the risk of a bank practicing fractional reserve lending of not being able to honour its checks.

Conversely, as the number of competitive banks diminishes, that is as the number of clients per bank rises, the likelihood of being “caught” practicing fractional reserve banking diminishes. In the extreme case if there is only one bank, it can practice fractional reserve banking without any fear of being caught so to speak.

In a free market then without the central bank, the fact that banks must clear their checks is likely to be a sufficient deterrent to practice fractional reserve banking.

We can thus conclude that what matters for the multiplier process is that the central bank is always ready to accommodate commercial banks’ expansion of credit out of thin air.

 

 

 

[1] Money and Inflation, L.Randall Wray – Jerome Levy Economics Institute