2012-10-22

Must read: the loans are the deposits, money multiplier is bunkum

Steve Keen goes over the money creation system again in: The myth of the money multiplier
if the Money Multiplier model doesn’t really describe how money is created, and how reserves figure in this, what does?

The short answer is “endogenous money”: bank lending creates deposits, so the decisions of banks to provide loans determine the level of money, and reserves are largely irrelevant. But today I want to attempt a longer answer that actually puts reserves in the picture, so I’m going to model (take a swig of coffee) a system with 3 banks: a “Buyer Bank” where a Buyer has both a deposit account and a credit card (or line of credit); a “Seller Bank” where a Seller has a deposit account, and a Central Bank that keeps the Reserve Accounts of both banks.

It’s an incomplete and unrealistic model because the money flow goes only one way – from Buyer to Seller, and therefore from Buyer Bank to Seller Bank – and therefore Buyer Bank must ultimately run out of Reserves. But it’s still effective in showing the basics of a more complete model in which money flows both ways.
He warns that it is a wonkish article, but it goes over the concept in depth. For those still trying to grasp the idea, it's worth a read. Here's one critical part, emphasis mine:
I hope the answer to that question is now obvious: of course it won’t. The Central Bank will either give Buyer Bank time to find the Reserves, or lend them to it. To do otherwise – to refuse to transfer Reserves from Buyer Bank to Seller Bank – would void the purchase made by the Buyer from the Seller (and note that this could happen with the Cash purchase just as easily as with the Card one). The system of commerce would break down. We’d have an interesting social system the instant after the Central Bank did such a thing, but it wouldn’t be called capitalism.

I hope this also explains why, in every country in the world where Reserve Requirements exist (and that’s not every country – Australia, for one, doesn’t have them), they are backward-looking: they depend on the level of deposits existing in the previous reporting period “and thus after banks have extended the credit demanded by their customers”. It should also explain the comment made by Alan Holmes over half a century ago that the Fed has “little or no choice” about doing this:

In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand.
Reserves come later. The central bank is the caboose, not the engine of money creation!

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