The Econtrarian
October 3, 2014
Legacy’s Senior Economic and Investment Advisor Paul L. Kasriel
The Money Multiplier – A Rite of Passage
for the Wrong Reason
The last time I taught college-level Money and Banking, over
five years ago, the textbook I was coerced into assigning
(but didn’t use) still had a section on the mechanics of
how the banking system in a fractional-reserve regime
could expand deposits (a component of “money”) by
some multiple of cash reserves provided by the central
bank. The Federal Reserve Bank of Chicago, one of my
former employers, had published a booklet, Modern Money
Mechanics, that explained how this process played out.
When I was at the Chicago Fed, this was one of the Bank’s
“bestsellers”. In my undergraduate Money and Banking
class, there were several questions on the final exam that
pertained to the mechanics of this seemingly “magical”
deposit-expansion process. I would be willing to wager
that to this day, there still are questions on most Money
and Banking final exams related to the mechanical process
of deposit expansion in the banking system. It is a Money
and Banking class rite of passage. Although the money
multiplier is a convenient pedagogical tool, I suspect that
the underlying economic significance of it is neglected in
most classrooms. And that underlying economic significance
is that the banking system in a fractional-reserve regime can,
along with the central bank, create credit figuratively out
of thin air. All kinds of credit, thin-air or not, enable their
recipients to increase their current spending on something.
But only thin-air credit unambiguously does not require
anyone else to simultaneously decrease his/her current
spending. Thus, a net increase in the supply of thin-air
credit carries the strong presumption that there will be a net
increase in total spending in the economy.
Now, for those of you who took a Money and Banking
class, let’s review the essence of the money multiplier. For
those of you who have not taken the class, let’s catch up.
Suppose that there are "n" separate banks in the banking
system, where "n" is a very large number. Now suppose
that the central bank purchases $100 of securities from
State Pension Fund that banks at Bank 1. State Pension
Fund’s deposits at Bank 1 have increased by $100. Bank 1’s
reserve account at the central bank has increased by $100.
MegaCorp, who is financing some new capital equipment to
be purchased from CoreCapGoods sells some new bonds in
an amount of $100 to State Pension Fund. MegaCorp and
CoreCapGoods both, coincidentally, bank at Bank 1. Let’s
stop here to consider what has happened to thin-air credit.
The central bank purchased $100 of securities from State
Pension Fund, paying for these securities with funds created
out of thin air. State Pension Fund then used these thin-air
funds to purchase $100 of new bonds issued by MegaCorp
to finance its new capital equipment purchase. $100 of
new thin-air credit has been created by the central bank.
Bank 1’s deposits increased by a net $100, owned first by
State Pension Fund, then transferred to MegaCorp and then
transferred to CoreCapGoods.
Back to the money multiplier. Assume that by law, banks
are required to hold as cash reserves at the central bank an
amount equal to 10% of the deposits on their books. Further
assume for simplicity’s sake, that banks earn no interest
on their cash reserves held at the central bank. So, Bank 1
has an additional $100 of cash reserves at the central bank,
but because its deposits went up by only $100, Bank 1 is
required to hold only $10 more of reserves at the central
bank. Bank 1 has an additional $90 of reserves at the central
bank that are in excess of what it is required to hold and
earn no interest. Now assume that Local Auto Dealer comes
into Bank 1 in hopes of getting a loan for $90 to finance its
inventory. Because Bank 1 has the capital to support new
Paul His
L. Kasriel,
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The economic
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and financial policies
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Paul L. Kasriel is Senior
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regarded economic researcher whose forecasts and Econtrarian perspectives have helped
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The Econtrarian
October 3, 2014
The Money Multiplier – A Rite of Passage for the Wrong Reason
Continued
not subject to reserve requirements, the magnitude of the
deposit/thin-air-credit multiplier will be increased. Even
when banks are not paid any interest on reserves held at the
central bank above and beyond what they are required to
hold, some banks still desire to hold some “excess” reserves.
To the degree that more excess reserves are desired, the
magnitude of the deposit/thin-air-credit multiplier will be
reduced.
loans and the loan terms are attractive to both parties, Local
Auto Dealer gets its loan, promptly writing a check payable
on its account at Bank 1 to Detroit Motor Vehicles, which
banks at Bank 2. The issuance of the $90 loan by Bank 1
increases thin-air credit by an additional $90. In total, thinair credit has increased a net $190 up at this point.
Bank 2 now finds its deposits up by $90 and its reserves at
the central bank up by $90. But Bank 2 is required to hold
More importantly, in the real world, banks do not behave
only an additional $9 of reserves at the central bank (10%
according to this mechanical deposit/credit multiplier
of the $90 in new deposits), so Bank 2 has $81 dollars
process although the end result of their behavior may be
in reserves in excess of what it is required to hold at the
approximated by it. Banks don’t
central bank. It just so happens
sit around waiting for deposits and
that VentureCap walks into Bank
The economic implication of
reserves to come to them if they
2 seeking a loan for $81 to fund
the
bank-deposit/bank-credit
have good lending prospects. If
the start-up of AppNoOneNeeds.
Bank 2 has the capital to support
multiplier is the banking system’s a bank is approached for a loan
it wishes to make, it does not
new loans and the loan terms
ability to create credit figuratively tell the prospective borrower to
are agreeable to both parties, so
out of thin air.
come back tomorrow when it
VentureCap gets its loan of $81.
might have more funds to lend.
The issuance of the $81 loan by
Rather, the bank funds the loan by purchasing the necessary
Bank 2 increases thin-air credit by an additional $81. In
funds in some interbank market. Moreover, if banks are
total, thin-air credit has increased a net $271 at this point.
constrained by capital adequacy, which they were in the last
AppNoOneNeeds deposits its $81 in start-up funds at its
financial crisis, they cannot support new loan growth even
bank, Bank 3. With those $81 in deposits, Bank 3 also
if they have a surfeit of central bank reserves. And, because
receives $81 in reserves at the central bank, of which, it only
banks’ required reserves are based on their deposit levels
is required to hold $8.10 (10% of $81). And so on. At the
in some previous week, the deposit/bank-credit multiplier
limit of n banks, the initial $100 of reserves created by
is not at all constrained by required reserves in the current
the central bank in its purchase of securities from State
week (right, Bob Laurent?).
Pension Fund, will have been “multiplied” into $1,000
But I digress. The point I am trying to make is that many
of new deposits in the banking system ($100/10%), $900
Money and Banking professors spend too much time
of thin-air credit created by the banking system and $100
teaching their students the mechanics of the bank-deposit/
of thin-air credit created by the central bank (or a net
bank-credit multiplier and not enough time explaining to
increase in total thin-air credit of $1,000).
them the important economic implication of the result of
There are all kinds of real-world complications that can
that multiplier – the banking system’s ability to create credit
reduce or increase the size of the deposit and thin-air credit
figuratively out of thin air.
multiplier – complications upon which Money and Banking
To illustrate the economic significance of thin-air credit vs.
final exam questions are famous. Recipients of deposits may
all other credit, consider Charts 1 and 2. Plotted in both
not want to redeposit the entire amount, preferring to hold
charts are the year-over-year percent changes in nominal
a portion as folding money, i.e., currency. An increase in
Gross Domestic Purchases (Gross Domestic Product +
currency held by the public is a drain on bank cash reserves
Imports – Exports) from Q2:1953 through Q2:2007. Plotted
that lowers the value of the multiplier. In real life in the
in Chart 1 are the year-over-year percent changes in the sum
U.S., only checkable bank deposits are subject to reserve
of U.S. depository institution (commercial banks, S&Ls
requirements. So, if an entity receives a deposit from some
and credit unions) credit and Fed credit from Q1:1953
other entity and chooses to hold the funds as a deposit
2
The Econtrarian
October 3, 2014
The Money Multiplier – A Rite of Passage for the Wrong Reason
Continued
through Q1:2007. This credit sum is a variation of the
thin-air credit to which I have referred. Thin-air credit
growth has been advanced by one quarter to illustrate
the effect of its growth this quarter on Gross Domestic
Purchases growth next quarter. The correlation coefficient
between thin-air credit growth advanced one quarter vs.
Gross Domestic Purchases growth during this period is
0.61 out of a maximum possible 1.00. Plotted in Chart
2 are year-over-year percent changes in total U.S. credit
outstanding excluding thin-air credit. This credit aggregate
also is advanced by one quarter. The correlation coefficient
between non-thin-air credit growth advanced one quarter
vs. Gross Domestic Purchases growth is 0.29, less than
half that of the correlation with thin-air credit growth.
So, here is my plea to Money and Banking professors.
Spend less time teaching the mechanics of the deposit/
bank-credit multiplier. Rather, spend more time explaining
how this process creates credit figuratively out of thin air
and why thin-air credit creation has such an important
effect on the business cycle. Who knows? Perhaps one
of your students will become a Fed official and can then
explain this concept to her Fed colleagues.n
Paul L. Kasriel
Senior Economic and Investment Advisor
Legacy Private Trust Company
Econtrarian, LLC
email: [email protected]
CHART 1
16
Sum of U.S. Depository Institution & Fed Credit
% change, year-to-year, advanced 1 quarter
Nominal Gross Domestic Purchases
% change, year-to-year
16
r = 0.61
12
12
8
8
4
4
0
0
-4
55
60
65
70
Source: Haver Analytics
75
80
85
90
95
00
05
-4
CHART 2
25
20
Total US Credit Outstanding Minus the Sum of U.S. Depository
Institution & Fed Credit
% change, year-to-year, advanced 1 quarter
Nominal Gross Domestic Purchases
% change, year-to-year
r = 0.29
25
20
15
15
10
10
5
5
0
0
-5
55
60
65
70
Source: Haver Analytics
75
80
85
90
95
00
05
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