Money Supply and the Money Multiplier
If people want less, then we exchange it back. People hold it as a low-cost medium of exchange and a safe store of value. In fact, over the past four years, U. This reflects low interest rates, which reduce the opportunity cost of holding currency. In fact, nearly two-thirds of U.
Monetary Policy, Money, and Inflation
When a country is going through economic or political turmoil, people tend to convert some of their financial assets to U. Such increased demand for U.
For monetary policy, the relevant metric is bank reserves. The Federal Reserve controls the quantity of bank reserves as it implements monetary policy. Before interest on reserves, the opportunity cost for holding noninterest-bearing bank reserves was the nominal short-term interest rate, such as the federal funds rate. Demand for reserves is downward sloping. That is, when the federal funds rate is low, the quantity of reserves banks want to hold increases.
Conventional monetary policy works by adjusting the amount of reserves so that the federal funds rate equals a target level at which supply and demand for reserves are in equilibrium. It is implemented by trading noninterest-bearing reserves for interest-bearing securities, typically short-term Treasury bills.
Money Multiplier and Reserve Ratio | Economics Help
Normally, banks have a strong incentive to put reserves to work by lending them out. If a bank were suddenly to find itself with a million dollars in excess reserves in its account, it would quickly try to find a creditworthy borrower and earn a return. If the banking system as a whole found itself with excess reserves, then the system would increase the availability of credit in the economy, drive private-sector borrowing rates lower, and spur economic activity.
Precisely this reasoning lies behind the classical monetary theories of multiple deposit creation and the money multiplier, which hold that an increase in the monetary base should lead to a proportional rise in the money stock. A critical explanation is that banks would rather hold reserves safely at the Fed instead of lending them out in a struggling economy loaded with risk.
The opportunity cost of holding reserves is low, while the risks in lending or investing in other assets seem high. Thus, at near-zero rates, demand for reserves can be extremely elastic.
The same logic holds for households and businesses. Given the weak economy and heightened uncertainty, they are hoarding cash instead of spending it. In a nutshell, the money multiplier has broken down see a discussion in Williams a. The numbers tell the story. Figure 3 shows that the money multiplier—as measured by the ratio of M2 to the monetary base—plummeted in late and has not recovered since. As a result, the ratio of nominal gross domestic product, which measures the total amount spent in the economy, to the monetary base fell even more precipitously, as the figure shows.
This ratio also has not recovered, illustrating how profoundly the linkage between the monetary base and the economy has broken. The most important reason has been a deliberate move to support financial markets and stimulate the economy. By mid-December , the Fed had lowered the federal funds rate essentially to zero. Yet the economy was still contracting very rapidly.
Standard rules of thumb and a range of model simulations recommended setting the federal funds rate below zero starting in late or early , something that was impossible to do see Chung et al. Instead, the Fed provided additional stimulus by purchasing longer-term securities, paid for by creating bank reserves. These purchases increased the demand for longer-term Treasuries and similar securities, which pushed up the prices of these assets, and thereby reduced longer-term interest rates. In turn, lower interest rates have improved financial conditions and helped stimulate real economic activity see Williams b for details.
The important point is that the additional stimulus to the economy from our asset purchases is primarily a result of lower interest rates, rather than a textbook process of reserve creation, leading to an increased money supply. It is through its effects on interest rates and other financial conditions that monetary policy affects the economy. The answer to these questions is no, and the reason is a profound, but largely unappreciated change in the inner workings of monetary policy. The change is that the Fed now pays interest on reserves.
The opportunity cost of holding reserves is now the difference between the federal funds rate and the interest rate on reserves. The Fed will likely raise the interest rate on reserves as it raises the target federal funds rate see Board of Governors Therefore, for banks, reserves at the Fed are close substitutes for Treasury bills in terms of return and safety. A Fed exchange of bank reserves that pay interest for a T-bill that carries a very similar interest rate has virtually no effect on the economy.
So lets see why! Allegedly, the money multiplier m transmits changes in the so-called monetary base MB the sum of bank reserves and currency at issue into changes in the money supply M.
Students then labour through algebra of varying complexity depending on their level of study they get bombarded with this nonsense several times throughout a typical economics degree to derive the m , which is most simply expressed as the inverse of the required reserve ratio. So if the central bank told private banks that they had to keep 10 per cent of total deposits as reserves then the required reserve ratio RRR would be 0.
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More complicated formulae are derived when you consider that people also will want to hold some of their deposits as cash. But these complications do not add anything to the story. The way this multiplier is alleged to work is explained as follows assuming the bank is required to hold 10 per cent of all deposits as reserves :. The following table and graphs shows you what the pattern involved is. They are self-explanatory. In this particular case, I have shown only 20 sequences.
In fact, this example would resolve at around 94 iterations as you can see on the graphs where the succesive loans, then fractional deposits get smaller and smaller and eventually become zero. The conception of the money multiplier is really as simple as that.
But while simple it is also wrong to the core! What it implies is that banks first of all take deposits to get funds which they can then on-lend. But prudential regulations require they keep a little in reserve. So we get this credit creation process ballooning out due to the fractional reserve requirements.
Well that is not at all like the real world. The way banks actually operate is to seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share. These loans are made independent of their reserve positions. Depending on the way the central bank accounts for commercial bank reserves, the latter will then seek funds to ensure they have the required reserves in the relevant accounting period.
There is typically a penalty for using this source of funds. But the reserve position per se will not matter.
So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans credit which creates new bank liabilities is unrelated to the reserve position of the bank. What about open market operations? These are allegedly how the central bank increases or decreases the money supply.
So assume the central bank wants to increase the money supply it would purchase bonds in the markets and, accordingly, add reserves to the banking system. Clearly, if the central bank wants to maintain control over the overnight interest rate it has to then drain the excess reserves which would require it offer the banks an interest-bearing asset commensurate with the overnight rate.
That is, it would have to sell bonds in an open market operation. The reverse is true if it tried to reduce the money supply by selling bonds. This drains reserves from the cash system and would probably leave some banks short of required reserves. Given the only remedy for an overall shortage of reserves is intervention from the central bank the attempt to decrease the money supply fails. It is clear that the central bank then is unable to control the volume of money in the system although it can control the price through its monetary policy settings.
The money multiplier is a flawed conception of how things work. The monetary base does not drive the money supply. In fact, the reverse is true. So the reserves at any point in time will be determined by the loans that the banks make independent of their reserve positions. So when you consider this in the light of the current policy debate you have to wonder what half the commentators are on! Mainstream economists are not the only group who demonstrate a misconception of the way the monetary system operates. So-called Circulation or Wickesellian models of the credit cycle which fail to include a government sector are examples of these flawed approaches.
In general, these models reject the money multiplier myth but replace it with another — that you can understand capitalism without understanding the essential role that Government plays in the monetary system. Accordingly, these models consider economies as being made up of households who supply productive factors and consume ; firms who produce and banks who loan working capital to firms in advance of production.
The workers then use their wages to consume and the firms then are able to pay back the banks. It is clear that the revolving fund of credit finance can expand to accommodate growth in private sector activity, at a rate related proportionately to the product of provisioning rates for capital adequacy requirements and the percentage of retained earnings available for leveraged lending.
For this very reason, the private sector can take up some of the slack created through government fiscal conservatism. However, and this is the crux of the modern monetary view, this growth will become unsustainable because net financial assets are either being destroyed or are not being created in insufficient quantity to meet the net saving needs of the private sector.
Private sector debt levels will be rising while the stock of net financial assets declines. But back to the main story! Why would these transactional circuits use the unit that the Government has legally sanctioned? Why would anyone accept the unit of account? You cannot answer these fundamental questions if you have excluded the Government sector from your analysis.
Further models that exclude government clearly cannot say anything about the important fiscal effects on bank reserves?
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