Does the Money Multiplier Exist?

Guest Author:  Edward Harrison of Credit Writedowns (London)

Edward Harrison is the founder of Credit Writedowns and a former strategy and finance executive with twenty years of business experience. He started his career as a diplomat and speaks six languages, a skill he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. He is a regular contributor at Seeking Alpha, Naked Capitalism, and Roubini Global Economics. Edward has often spoken on television and radio in the US, the UK, Canada and Russia.


The Federal Reserve Board’s Seth B. Carpenter and Selva Demiralp have a great paper out on the economics of bank reserves (hat tip FT Alphaville and Pragmatic Capitalism). The question: Does the Money Multiplier Exist? The short answer: yes, but only as an ex-post accounting identity!

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.


Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending.

Let me break the argument down for you in layman’s terms.

Once upon a time economists believed there was this thing called the market for loanable funds. According to this theory, a central bank controlled the creation of credit by increasing or decreasing the supply of reserves or loanable funds available to depositary institutions.

So, for example, if the Federal Reserve sold Treasury bonds to a primary dealer – say Kidder, Peabody to use a now extinct and uncontroversial example –  in exchange for money, the supply of loanable funds would shrink. This would, in theory, decrease available credit and cool off an overheated economy.  According to this theory, the reverse would also be true, namely that the Fed’s buying assets with money it printed out of thin air would increase the supply of credit.

The monetarist history of the Great Depression by Milton Friedman and Anna Schwarz uses the loanable funds theory to argue that the Great Depression was all the Fed’s fault because it was too restrictive. Had the Federal Reserve been more expansionary in its monetary policy, there never would have been a Great Depression or so the theory goes.

As it turns out, this is total baloney. There isn’t a finite pool of funds which can move around “demanding” higher interest rates.

  1. In practice, banks don’t wait for the reserves to be available to issue loans. They make loans first and then borrow the reserves in the interbank market. The loans come first, not the reserves. A small private bank in Kansas can’t turn into Bank of America overnight. There is a limit to lending. The limit on bank lending is not reserves but capital and leverage! Ask the Canadians who have no reserve requirement.
  2. If you haven’t noticed, banks’ excess reserves are piling up at the Federal Reserve right now. The ‘loanable funds’ are there waiting to be used. Why aren’t they using them?  Because there aren’t enough creditworthy borrowers or well-capitalized lenders to increase credit significantly right now. This was exactly the same spectacle we witnessed during the Great Depression, by the way.

Marshall Auerback puts it well:

In the U. S., when a bank makes a loan, this loan creates a deposit for the borrower. If the bank then ends up with a reserve requirement that it cannot meet by borrowing from other banks, it receives an overdraft at the Fed automatically (at the Fed’s stated penalty rate), which the bank then clears by borrowing from other banks or by posting collateral for an overnight loan from the Fed. Similarly, if the borrower withdraws the deposit to make a purchase and the bank does not have sufficient reserve balances to cover the withdrawal, the Fed provides an overdraft automatically, which again the bank then clears either by borrowing from other banks or by posting collateral for an overnight loan from the Fed.

The point of all this is that the bank clearly does not have to be holding prior reserve balances before it creates a loan. In fact, the bank’s ability to create a new loan and along with it a new deposit has NOTHING to do with how many or how few reserve balances it is holding.

What is required to drive lending is a creditworthy borrower on the other side of the bank lending officer’s desk, which means an employed borrower, whose income allows him to sustain regular repayments. Absent that, there will be no lending activity. It is pointless to blame the evil bankers for this of state affairs, since they don’t control fiscal policy, which is the remit of the Treasury.

For all the talk from policy makers about not repeating the mistakes of Great Depression, we seem to be perilously close to doing precisely that. This is largely based on a poor understanding of the economic dynamics of that period, even by that noted scholar of the Great Depression, Ben Bernanke.  –The Real Reason Banks Aren’t Lending

I am reminded here of Ray Dalio’s term ‘the D-Process’ which describes a long-term debt cycle which ends in default and bankruptcy. He says:

The reason [credit easing] hasn’t actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece — banks and investment banks and whatever is left of the financial sector — that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.  –A conversation with Bridgewater Associates’ Ray Dalio

Now, the money multiplier – which is the mathematical ratio of base money to larger monetary aggregates like m2 m3 or MZM – exists. It’s just that the Fed doesn’t control it. They can print all the money they want, but if creditors and debtors aren’t solvent there isn’t going to be any additional lending. They are pushing on a string (see Pushing on a string and similar notions on monetary policy ineffectiveness from December 2008 when the Fed first tried QE).

So will QE2 aka QE-lite work? The short answer is no. See the long answer here.

Source: Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist? (pdf) – Federal Reserve Board