The Myth of the Money Multiplier – Money Creation in Modern Banking

Throughout our formal education, we will inevitably have been taught several concepts incorrectly (or several incorrect concepts). The classic Bohr model of an atom’s structure or the lipid bilayer of a cell membrane are two such simplifications. This is, however, entirely by design. Textbooks, even at the university level, sacrifice a degree of factuality to ensure that the broader concepts are understood at large across a variety of subjects, and rightly so. However, it would be hoped an individual proceeding to specialize in a particular subject would eventually dispel with these training wheels. For anyone involved in economics and financial systems, the money multiplier is one such falsehood.

A Primer on the Multiplier

The money multiplier model is a traditional macroeconomic theory explaining the mechanisms by which central banks influence the money supply. These central authorities impose constraints on a bank’s ability to lend money through the reserve ratio; the fraction of all deposits that must be held as reserves. The remaining sum is lent, deposited once more, lent out again at the reserve ratio and so on. The effect, assuming a reserve ratio of 16% and a 500$ injection by the central bank, is as follows:

The commercial bank is then made to act solely as an intermediary. Deposits are a result of household saving, and only these deposits less the reserve requirement can be lent. Both of these assumptions prove false in the modern economy. The former is a misconception at the aggregate level. A household does not need to ‘save’ or set aside funds for them to appear as deposits in the system. Money exchanged for goods and services will eventually make their way to the depository accounts of that party on the other side of the exchange. As for the latter, rather than have its lending practices be constrained by central bank reserve requirements, the commercial bank simply creates the money.

Fountain Pen Deposits

Though the Federal Reserve officially eliminated reserve restrictions for depository institutions in 2020, reserve requirements have been an irrelevant aspect of monetary policy in most economies for some time. A bank lending to an individual simply credits the account with deposits, simultaneously recognizing an asset and a liability. This is sometimes referred to as “fountain pen money” given it appears at the stroke of a banker’s pen. It is important to recognize how this differs from a typical deposit as it pertains to both the money supply and central bank reserves.

Suppose an individual needs to make a 1000$ in online payments for an extraordinary quantity of gourmet avocado toast. They deposit some cash into their account to fund the transaction. The deposit simply alters the form in which the individual’s personal assets were held. The cash, which used to be a liability of the central bank, is now an IOU issued by the commercial bank. Against this liability, the bank recognizes 1000$ in assets as reserves.

In our second example, the individual faces an unfortunate shortage of cash savings. This, however, is not to stop our culinary connoisseur, and a most prudent 1000$ loan is taken out.

The individual’s account is now credited not with their cash deposit, but rather ‘new’ money created by the commercial bank. In other words, the loan has expanded the supply of money. Bank deposits are then only a record of amounts owed to customers, and not the assets lent out within themselves i.e. the loan issuance was not restrained by the bank’s reserves. Critically, there is no change in reserves in circulation – the central bank’s balance sheet remains unaffected. The deposit created by virtue of the loan is a claim on the commercial and not central bank. They are not reserves but rather carry the potential for a reserve transfer (explained below).

The question that now arises is as follows: what is to stop the commercial bank from issuing as many loans as it wishes given its powers are constrained neither by reserves nor the level of deposits?

Not So Free Money

It may not be immediately obvious what is to stop the commercial bank from blasting the money supply to infinity. To start, note that what the borrower chooses to do with their funds are not controlled by the creditor and may immediately shrink the money supply. Just as the creation of a loan expands the money supply, repayment of a loan contracts it. The borrower may choose to settle existing lines of credit or transact with an entity that does so for themself. This is the first countervailing force against inflation.

Second, repayment does not grant the bank the principal sum (recall that the loan does not increase the bank’s reserves). The bank’s profit is determined only by the rate charged on the loan against the rate it pays on its own borrowings. This is referred to as ‘net interest margin’ – the second countervailing force against inflation.

Three features of the above graph encapsulate the bank’s decision-making process with regard to loan volume.

1. The Supply & Demand of Money: The average interest the bank earns across its loans will fall as it attempts to increase issuance. Naturally, to induce customers away from competing institutions, as well as attract new borrowers altogether, it will either (i) offer more enticing terms on credit, directly lowering interest earned or (ii) offer the same loan facility to individuals with more suspect credit backgrounds, indirectly lowering interest earned through defaults.

2. The Fed Funds Rate: A higher federal (or any other central bank) interest rate will increase the cost of money in the economy. Consequently, banks will offer steeper terms to borrowers and bring in greater total interest. This does not come free – greater interest is offset to an extent by the higher cost of borrowing for the bank (given by the dotted lines). For example, in a high-rate environment, money market funds and other fixed-income securities will offer households a greater rate of return. Banks will have to respond by offering competing rates on deposits. The difference between the banks cost of borrowing and interest on lending will then depend on monetary policy.

3. Marginal Revenue & Profit Maximization: As a result of the upwards sloping cost of borrowing line (the more you demand, the more you pay) and the diminishing returns on the marginal loan, the bank will stop issuing loans exactly at the point where it maximizes net interest margin.

Do Reserves Matter at All

Reserves at the central bank are used primarily to settle interbank transactions. For instance, if a customer uses its deposits at Bank X to pay an individual banking with Bank Y, X will settle the transaction through a transfer of reserves to Y’s account at the central authority. We also know that for the most part, a borrower can do with their new deposit as they wish. Thus, the more loans a bank makes, the more it exposes itself to the inevitable risk of deposits being transacted elsewhere. These transactions will require reserves to settle. If the bank has no such reserves to speak of, it is considered illiquid and must borrow from other depository institutions or the central authority as a last resort. To guard against liquidity risk, the bank may attempt to fix some of its deposits for a certain time period. The depositor in question will require compensation in the form of a more lucrative interest rate. This is the trade-off between liquidity and profitability and is informed in part by the level of reserves held at the central authority.