The money multiplier model does not explain credit expansion

John Hermann

A money multiplier is one of various closely related ratios of commercial bank credit money to central bank money (“base money” consisting of creditary reserves and currency) under a fractional reserve banking system. Most often, it measures the minimal quantity of reserves required to be held by a commercial bank – either by regulation or in conformity with prudential and liquidity requirements – consistent with the volume of its deposits.

The money multiplier model of credit money expansion asserts that, in a fractional-reserve banking system, the total quantity of loans that commercial banks can extend (the bank credit money they are allowed to create) is a multiple of the quantity of reserves they hold in advance of the loans they extend. This multiple is a money multiplier and is the reciprocal if the reserve ratio.

However this money multiplier explanation, which is found in mainstream economics textbooks, is a completely wrong description of how fractional reserve banking actually works in the real world.  According to Prof Steve Keen, two hypotheses about the nature of money follow from the money multiplier model. These are:

1. The creation of credit money should happen after the creation of government money. In the model, the banking system can’t create credit until it receives new deposits from the public (that in turn originate from the government) and therefore finds itself with excess reserves that it can lend out. Since the lending, depositing and re-lending process takes time, there should be a substantial time lag between an injection of new government-created money and the growth of credit money.
2. The amount of money in the economy should exceed the amount of debt to the banking system, with the difference attributable to the government’s initial creation of base money.

Both of these hypotheses are strongly contradicted by available economic data. Testing the first hypothesis requires some data analysis, which was done by two leading neoclassical economists (Kydland & Prescott, Business Cycles: Real Facts and a Monetary Myth, Federal Reserve Bank of Minneapolis Quarterly Review, Spring 1990). Their empirical conclusion was:

There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly. (p. 11)

The difference in the behavior of M1 and M2 suggests that the difference of these aggregates (M2 minus M1) should be considered.  The difference of M2 – M1 leads the cycle by even more than M2, with the lead being about three quarters. (p. 12)

Thus rather than credit money being created with a lag after government money, the data shows that credit money is created first, up to a year before there are changes in base money. This contradicts the money multiplier model of how credit and debt are created: rather than base money being needed to “seed” the credit creation process, credit is created first and then, after that, base money changes.

And it doesn’t take sophisticated statistics to show that the second prediction is wrong – all one needs to do is look at the ratio of private debt to money.

The actual mechanics of bank credit expansion are as follows. Suppose that the reserve ratio is designated by r (<1). This ratio might be a statutory requirement or it might be a voluntary liquidity requirement, depending on the country we are talking about. Suppose also that a commercial bank has deposits of magnitude Y and reserves of magnitude rY. In this situation there are no reserves excess to the bank’s liquidity requirement. Let us also assume that the bank’s assets and capital satisfy the capital adequacy requirement for solvency.

If the bank now decides to make a retail loan of magnitude X, then it will create a new deposit of that magnitude in the borrower’s demand account with that bank. The bank must now look for excess reserves of magnitude rX in order to satisfy the liquidity requirement. One way of doing so is to borrow reserves from the wholesale markets. If the central bank’s monetary policy is being adequately implemented, then there should not be a shortage of reserves across the entire banking system for the purpose of accommodating this requirement (and in the last resort, reserve funds may be borrowed from the central bank itself).

Another way of gaining the required excess reserves is to persuade one of the bank’s depositors to move a deposit of magnitude rX from a demand account into a term account (interest-bearing account). This action will free up reserves of magnitude rX, because there is a zero (or close to zero) reserve requirement for term accounts. Whether this method of gaining excess reserves is preferable to wholesale borrowing depends on the respective interest rates charged by the markets and the interest returns offered to the depositors, as well as the demand for interest-bearing deposits by the bank’s customers.

In conclusion, commercial bank lending is not reserve constrained. Banks lend to their customers first and, if necessary, look for the reserves they need later.