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The Myth of the Money Multiplier

The following comes from an excellent new paper from the Fed.  The paper describes the myth of the money multiplier and is an absolute must read for anyone who is trying to fully understand the current environment.  It turns much of textbook economics on its head and describes in large part why the bank rescue plan and the idea of banks being reserve constrained is entirely wrong:

“The role of reserves and money in macroeconomics has a long history.  Simple textbook treatments of the money multiplier give the quantity of bank reserves a causal role in determining the quantity of money and bank lending and thus the transmission mechanism of monetary policy.  This role results from the assumptions that reserve requirements generate a direct and tight linkage between money and reserves and that the central bank controls the money supply by adjusting the quantity of reserves through open market operations.  Using data from recent decades, we have demonstrated that this simple textbook link is implausible in the United States for a number of reasons. First, when money is measured as M2, only a small portion of it is reservable and thus only a small portion is linked to the level of reserve balances the Fed provides through open market operations.  Second, except for a brief period in the early 1980s, the Fed has traditionally aimed to control the federal funds rate rather than the quantity of reserves.  Third, reserve balances are not identical to required reserves, and the federal funds rate is the interest rate in the market for all reserve balances, not just required reserves.  Reserve balances are supplied elastically at the target funds rate.  Finally, reservable liabilities fund only a small fraction of bank lending and the evidence suggests that they are not the marginal source data for the most liquid and well-capitalized banks.  Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected.  Specifically, our results indicate that bank loan supply does not respond to changes in monetary policy through a bank lending channel, no matter how we group the banks.

Our evidence against the bank lending channel at the aggregate level is consistent with other recent studies such as Black, Hancock, and Passmore (2007), who reach a similar conclusion about the limited scope of the bank lending channel in the United States, and Cetorelli and Goldberg (2008), who point out the importance of globalization as a way to insulate the banks from domestic monetary policy shocks.  Our findings are also consistent with the predictions of Bernanke and Gertler (1995) from over a decade ago that the importance of the traditional bank lending channel would likely diminish over time as depository institutions gained easier access to external funding.

Our evidence against the bank lending channel at the micro level is consistent with Oliner and Rudebusch (1995), but it contrasts previous findings of a lending channel for small, illiquid, or undercapitalized banks (see Kashyap and Stein (2000), Kishan and Opiela, (2000) and Jayartne and Morgan (2000)).  What is common in all these studies is that their sample periods cover the period prior to 1995, when reservable deposits constituted the largest source of funding.  As we have shown in Table 3, this is no longer a feature that characterizes bank balance sheets in the post-1994 period.  Furthermore, Kashyap and Stein (2000) and Kishan and Opiela (2000) interpret a change in the sensitivity of bank lending to monetary policy as evidence of a bank lending channel.  We argue that changes in the sensitivity of bank loans may of funding, either.  All of these points are a reflection of the institutional structure of the U.S. banking system and suggest that the textbook role of money is not operative. While the institutional facts alone provide compelling support for our view, we also demonstrate empirically that the relationships implied by the money multiplier do not exist in the stem from the demand side, and that a better test for the lending channel is to check whether bank loans are financed by reservable deposits.  Our findings suggest that this is not the case.

In general, our results echo Romer and Romer (1990)’s version of the Modigliani-Miller theorem for banking firms.  They argue that banks are indifferent between reservable deposits and non-reservable deposits.  Hence, shocks to reservable deposits do not affect their lending decisions, and changes to reserves only serve to alter the mix of reservable and non-reservable deposits.  Our findings in this paper support the argument that shocks to reservable deposits do not change banks’ lending decisions.

Since 2008, the Federal Reserve has supplied an enormous quantity of reserve balances relative to historical levels as a result of a set of nontraditional policy actions.  These actions were taken to stabilize short-term funding markets and to provide additional monetary policy stimulus at a time when the federal funds rate was at its effective lower bound.  The question arises whether or not this unprecedented rise in reserve balances ought to lead to a sharp rise in money and lending.  The results in this paper suggest that the quantity of reserve balances itself is not likely to trigger a rapid increase in lending.  To be sure, the low level of interest rates could stimulate demand for loans and lead to increased lending, but the narrow, textbook money multiplier does not appear to be a useful means of assessing the implications of monetary policy for future money growth or bank lending.” (emphasis added)

The key point here is to get the causation right.  The money multiplier concept implies that reserves are used to make new loans or that there is some necessary ratio between reserves and new loans.  But the exact opposite is true.  Banks make loans and find reserves after the fact.  Bank lending is not reserve constrained.  So the causation moves in the exact opposite direction from what most textbooks teach us.  Bank loans create new deposits and banks find the necessary reserves after the fact if they must.  

This primer I wrote will explain this concept more fully.


See the following for more detail on the basics of banking:

Also see this Fed paper on this topic:

The Bank of England also has a good paper on the mechanics of endogenous money here.

* Updated with new research.

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