The Myth of the Money Multiplier

The textbook money multiplier asserts that the lending of banks automatically expands the credit money supply to a multiple of their aggregate reserves.  In its basic form, that multiple is equal to the reciprocal of the required reserve ratio.  In the U.S. the required ratio is currently 10%, which implies the money supply should be about ten times larger than the aggregate reserves of banks.  Then what are we to make of the money multiplier concept in a country like Canada where the reserve requirement is zero?

The Myth 

The money multiplier concept implicitly assumes that the Fed controls the money supply by setting the required reserve ratio, and then issuing enough reserves to enable aggregate bank lending to a multiple of that ratio.  Since demand deposits in U.S. banks remain at roughly the expected multiple of reserves, that would seem to confirm the money multiplier thesis.  It is then easy to conclude that the causal relation runs from reserves to loans, and thus to deposits. In truth, it runs in exactly the opposite direction. 

The money multiplier concept represents a misunderstanding about how the credit money supply grows.  Banks with adequate capital can and do lend without adequate reserves on hand.  If a bank has a creditworthy borrower and a profitable lending opportunity, it will issue the loan and then if necessary borrow reserves in the money market to meet the reserve ratio requirement.

Managing Aggregate Reserves 

A bank's reserves are counted as the average held during successive 14-day periods.  That averaging allows a bank to run below its required level on any given day and thereby provides flexibility in meeting the reserve requirements.  Most large banks are deposit poor and must borrow the required reserves in the money market.  Smaller banks are generally deposit rich and often lend their excess reserves to larger banks. 

As a bank increases its lending, that increases its demand deposits so it must increase its holding of reserves.  If there is a shortage of aggregate reserves in the banking system, only the Fed can make up the difference.  As long as the Fed's policy is to control the Fed funds rate, it must supply whatever reserves are required to meet the demand.  Conversely as aggregate bank lending decreases, the Fed must drain reserves.  Total reserves are thus a dependent variable, not a control variable as implied in the money multiplier concept.

The Uses of Excess Reserves 

A bank gains reserves when someone deposits cash or a check written on another bank.  The deposit increases the bank's assets and liabilities equally, thus leaving its capital unchanged.  Whether the new deposit increases the bank's lending power depends on its capital adequacy, i.e. the ratio of its capital to its risk-weighted assets.  A new deposit does not affect the bank's capital ratio since reserves are risk-free.  However new loans by the bank would add to its risk-weighted assets and thus reduce its capital ratio.  If the bank were loaned up to its capital ratio limit, the additional reserves would not increase its lending power.  

Banks are seldom loaned up to the capital adequacy constraint.  In that case whether the added reserves will be used to support additional lending depends on the opportunities that exist at the time.  Reserves earn no interest, so banks with excess reserves are likely to lend them at interest to other banks in the Fed funds market.  If there isn't sufficient demand for reserves, the Fed will have to recapture the excess in order to maintain control of the Fed funds rate.  It does that by selling T-bills from its own portfolio. 

The next article presents a case history that exposes another textbook myth, namely that varying the reserve ratio requirement is a way of controlling the credit money supply.