Research & Commentary

Deflation Basics Series: The Money Multiplier

In the Quantity Theory of Money section of our Deflation Basics Series, we learned how the level of prices in an economy are affected by the amount of money sloshing around. In this section, we will learn about how money is created in the first place.

Money is created courtesy of a magic trick known commonly as the money multiplier, or the multiplier effect. The money multiplier is intertwined with something called fractional-reserve banking.

Modern fractional-reserve banking has its origins in goldsmiths, such as the Amsterdam Exchange Bank, founded in 1609. People would deposit their gold and silver for safekeeping and the goldsmith would issue them a receipt. These receipts were then used in trade – becoming “banknotes.” But the goldsmiths realized that not everyone would come to redeem their metal at the same time and so, gradually, they started investing some of it in interest-bearing loans. Gradually, goldsmiths changed from being guardians of metal (for a fee), to institutions that charge and earn interest (what we think of now as banks) and fractional-reserve banking was born.

Painting of Amsterdam Town Hall, site of the Amsterdam Exchange Bank, Pieter Janszoon Saenredam (1597–1665), Source: WikiCommons {{PD-1923}}

These early banks had to take a guess as to how much of their customers’ metal they could lend out and how much they had to leave in the vault in case the customer came to collect it. Many went bust due to miscalculations of this metric. Then, in 1668, Sweden became the first country in the world to adopt a “central bank” which had the power to tell all the other banks how much of their deposits they should hold “on reserve” to satisfy potential customer demand. Many other countries started to adopt the same structure and that is, essentially, where we are today. In most countries, the central bank will set out what level of reserves commercial banks should hold. If no reserve requirement is set, a capital requirement is set, which is different, but has a similar theoretical aim – a bank must set reserves or assets aside in order to remain solvent if everyone decided to come and get their money back at the same time.

Let’s take a very basic example of a country where the central bank tells commercial banks that they must hold 10% of their customers’ deposits as reserves.

ABC Bank has just been founded and their first customer, Janet, deposits a crisp $100 bill with them. Then Ben comes along and wants to borrow some money. ABC Bank lends Ben $90, keeping $10 (10%) of Janet’s money in reserve in case she wants to make a withdrawal. Ben then takes his $90 and deposits it in XYZ Bank. Where there was just one deposit, there are now two – Janet’s $100 and Ben’s $90. Of course, there is still only Janet’s $100 bill in physical note form, but deposits in commercial banks now equal $190. Hey presto – money has just been created.

This process continues. Alan comes along to XYZ bank and wants to borrow some money. XYZ bank lend him $81, 90% of Ben’s deposit (keeping 10% back as reserves). Alan takes his $81 and deposits it in ABC Bank, where his account is. Commercial bank deposits now amount to $271 – yet still the only physical bank note in the system is Janet’s $100 bill. The process continues as below. Each new loan results in a new deposit, 90% of which can then be used as another new loan, creating a new deposit and so on.

Bank Deposit of $100 -> $90 Loan -> Bank Deposit of $90 -> $81 Loan -> Bank Deposit of $81 -> $72.90 -> Etc. 

Thus, fractional-reserve banking enables the creation of money.

You won’t be surprised to know that the creation of money in the modern banking system is much more complicated than our example, but the mechanics are the same: new loans = new deposits = new money.

The percentage of their deposits that the central bank tells commercial banks to hold in reserve is known as the Reserve Ratio (RR). The reserves are held in accounts in the central bank. Put simply, the Money Multiplier (m) is the reciprocal of the reserve ratio.

m = 1/RR

So if the RR is 10%, as in our example above, m = 1/0.1 = 10.

If the RR is 20%, m = 1/0.2 = 5.

Once we have the MM, we can calculate the “multiplier effect” on bank deposits. To find out how much new money could be created, we simply divide deposits by RR. Using our example above, if we divide Janet’s initial $100 deposit by the RR of 0.1, we get $1,000. In other words, Janet’s $100 deposit could be multiplied into $1,000 if the lending and deposit process continued as above. With a Reserve Ratio of 10%, $900 new dollars could be created from a $100 deposit.

In reality, of course, the nuances of the banking system mean that our basic example is not a reflection of reality. However, new loans = new deposits = new money holds under the fractional-reserve banking system – it’s just a matter of arguing about the extent of money creation. In fact, some countries such as the UK, Sweden, Canada and Australia do not operate a Reserve Requirement. The UK’s Bank of England in particular has been a staunch critic of the Money Multiplier, arguing that it is too simplistic a framework in which to understand the entirety of money creation. They are probably correct.

Aside from the Reserve Ratio, another way of limiting how much a bank can lend is by requiring them to hold a certain amount of capital. This is what the Basel III banking regulation does. In fact, under Basel III, due to be implemented in 2018 to 2019, there is also a stipulation that banks hold enough short-term liquid assets to cover 30-days net expected outflow. So, whether banks are required to hold reserves or capital, the aim is to provide a cushion against deposit withdrawals.

On a macro level, a way of estimating the Money Multiplier is to divide money stock by the monetary base.

m = money stock / monetary base

In the USA, we can define money stock as M1, and the monetary base as the St. Louis Adjusted Monetary Base.

The Federal Reserve defines M1 as “…(1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler’s checks of nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts, and demand deposits at thrift institutions.”

The St. Louis Adjusted Monetary Base is the sum of currency (including coin) in circulation outside Federal Reserve Banks and the U.S. Treasury, plus deposits held by depository institutions at Federal Reserve Banks.

A simple way to think of it is that the St. Louis Adjusted Monetary Base is cash, and M1 is cash plus deposit accounts at banks.

The chart below shows the Money Multiplier (m) for the USA from 1959 to 2017. It had been steadily declining up until the 1990s, and then the downtrend started to accelerate. During the financial crisis of 2008/2009, m dropped below 1, meaning that the central bank was creating more money than the commercial banks. m below 1 indicates that commercial banks are holding excess reserves and are not using them to lend (create money) – a sign of fragile confidence in the economy.

Conclusion

The Money Multiplier (m) is a measurement of how much money is being created by commercial banks operating under a fractional-reserve system. It is an important metric for gauging confidence in the economy.

 

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