to the Money?
In April 1992 the Fed lowered the required reserve ratio on demand
deposits from 12% to 10%. According to textbook theory, that
would have freed up enough bank
for lending and resulted in a 20% increase in demand deposits.
What actually happened?
First the facts
Here are the monthly average figures for the period
June 1992, copied from the Fed Board of Governors website. All
are in billions, and non-seasonally adjusted.
Fed Funds Rate
Note the changes between March and April. It is apparent that
the Fed funds target rate was lowered from 4.0% to 3.75% at the same
the reserve ratio was lowered. The Fed stated that it was
banks to increase their lending.
The drop in the required reserves ratio should have
2% of the total reserves of $56B, or $1.1B, into excess reserves.
According to the money multiplier, that excess should have resulted in
an increase of about $11B in demand deposits. At first blush that
is just about what appears to have happened. But why did total
drop by nearly $6B at the same time?
Adjusting the Reserves
While the Fed was
giving with one
hand, it was taking away with the other. The Fed funds rate
the overnight lending rate between banks, is a money market rate that
Fed steers towards its target through its control of excess
Had the Fed allowed excess reserves to double when it
lowered the required
reserve ratio, the FFR would have collapsed. In order to avoid
the Fed sold from its stock of Treasury securities enough to soak up
of the new excess reserves. This converted what would have been
excess bank reserves into securities and explains why total reserves
by about $6B.
No Surge in the Money Supply
Demand deposits show the typical seasonal variation,
with the usual
peak in the tax month of April. A part of the monthly increase in
total reserves and demand deposits is due to the upward trend of a
economy. During the previous year, 1991, the average growth rate
of total reserves was $0.4B per month, and of demand deposits was $1.9B
The secular growth rate in demand deposits over the
whole six month
period shown is just about what would be expected based on the prior
data. Some part of that growth can also be attributed to the
of the Fed funds rate. Taking these factors into account, there
no evidence of a surge in the money supply as would be expected from
money multiplier effect.
The lesson here is that the textbook money multiplier
has no real explanatory
power. It is merely an after-the-fact observation of the
The important point is that the money supply increases as a function of
demand. Demand in turn depends on many things, only one of which
is the price of money as set by the Fed.
Why the Fed Changed the Reserve
The reason the Fed lowered the reserve ratio requirement
in 1992 was
more than its announced desire to increase bank lending. It was
to improve the financial health and the competitive position of U.S.
Reserves earn no interest and thus are a drag on bank
Large banks in particular were not in good shape. They were still
digging out of their bad loans of the 1980s, and were losing the
with foreign banks, most of which have no reserve requirements.
the lowered reserve ratio and the further lowering of the FFR, to 3.25%
in July and 3.0% in October 1992, the Fed gave a very strong boost to
earnings of banks, for which they can thank the Fed Chairman, Alan