The importance of excess reserves

In some presentations of the money multiplier theory, the further simplification is made that commercial banks only hold the reserves that are legally required by the monetary authorities so that the R/D ratio is determined directly by the central banks.^[3] In many countries the monetary authorities maintain reserve requirements that secure a minimum level of reserves at all times. However, commercial banks may often hold excess reserves, i.e. reserves held in excess of the legal reserve requirements. This is for instance the case in countries that do not impose legal reserve requirements at all like the United States,^[6][7] the United Kingdom, Canada, Australia, New Zealand and the Scandinavian countries.^[8][9] The possibility of banks voluntarily choosing to hold excess reserves, in amounts that may change over time as the opportunity costs for banks change, are one reason why the monetary multiplier may not be stable. For instance, following the introduction of interest rates on excess reserves in the US, a large growth in excess reserves occurred in the Financial crisis of 2007–2010, US bank excess reserves growing over 500-fold, from under $2 billion in August 2008 to over $1,000 billion in November 2009.^[10][11]

The insight that banks may adjust their reserve/deposit ratio endogenously, making the money multiplier unstable, is old. Paul Samuelson noted in his bestselling textbook in 1948 that:

By increasing the volume of their government securities and loans and by lowering Member Bank legal reserve requirements, the Reserve Banks can encourage an increase in the supply of money and bank deposits. They can encourage but, without taking drastic action, they cannot compel. For in the middle of a deep depression just when we want Reserve policy to be most effective, the Member Banks are likely to be timid about buying new investments or making loans. If the Reserve authorities buy government bonds in the open market and thereby swell bank reserves, the banks will not put these funds to work but will simply hold reserves. Result: no 5 for 1, “no nothing,” simply a substitution on the bank’s balance sheet of idle cash for old government bonds.

— (Samuelson 1948, pp. 353–354)

Restated, increases in central bank money may not result in commercial bank money because the money is not required to be lent out – it may instead result in a growth of unlent (i.e. excess) reserves. This situation has been referred to as "pushing on a string": withdrawal of central bank money compels commercial banks to curtail lending (one can pull money via this mechanism), but input of central bank money does not compel commercial banks to lend (one cannot push via this mechanism).^[12]

The amount of its assets that a bank chooses to hold as excess reserves is a decreasing function of the amount by which the market rate for loans to the general public from commercial banks exceeds the interest rate on excess reserves and of the amount by which the market rate for loans to other banks (in the US, the federal funds rate) exceeds the interest rate on excess reserves. Since the money multiplier in turn depends negatively on the desired reserve/deposit ratio, the money multiplier depends positively on these two opportunity costs. Moreover, the public’s choice of the currency/deposit ratio depends negatively on market rates of return on highly liquid substitutes for currency; since the currency ratio negatively affects the money multiplier, the money multiplier is positively affected by the return on these substitutes. Note that when making predictions assuming a constant multiplier, the predictions are valid only if these ratios do not in fact change. Sometimes this holds, and sometimes it does not; for example, increases in central bank money (i.e. base money) may result in increases in commercial bank money – and will, if these ratios (and thus multiplier) stay constant – or may result in increases in excess reserves but little or no change in commercial bank money, in which case the reserve–deposit ratio will grow and the multiplier will fall.^[13]

"Loans first" model

An alternative interpretation of the direction of causality in the identity described above is that the connection between the money supply and the monetary base goes from the former to the latter: Interest-rate-targeting central banks supply whatever amount of reserves that the banking system demands, given the reserve requirements and the amount of deposits that have been created.^[14]

In this alternative model of money creation, loans are first extended by commercial banks – say, $1,000 of loans, which may then require that the bank borrow $100 of reserves either from depositors or other private sources of financing, or from the central bank. This view is advanced in endogenous money theories.^[15] It is also occasionally referred to as a "Loans first" model as opposed to the traditional multiplier theory, which can be labelled a "Reserves first" model.^[16]

Historical attempts to steer the money supply

Historically, central banks have in some periods used strategies of trying to target a certain level or growth rate of money supply, in particular during the late 1970s and 1980s, inspired by monetarist theory and the quantity theory of money.^[17][18] However, these strategies turned out to not work very well and were abandoned again.^[19] In the United States, short-term interest rates became fourfould more volatile during the years 1979-1982 when the Federal Reserve adopted a moderate version of monetary base control, and the targeted monetary aggregate at the time, M1, even increased its short-term volatility.^[1]

Current monetary policy

Starting in the early 1990s, a fundamental rethinking of monetary policy took place in major central banks, shifting to targeting inflation rather than monetary growth and generally using interest rates to implement goals rather than quantitative measures like holding the quantity of base money at fixed levels.^{[19]: 484–485} As a result, modern central banks hardly ever conduct their policies by trying to control the money supply,^[20] implying also that the monetary multiplier theory has become more irrelevant as a tool to understand current monetary policy.^[6][21]

Charles Goodhart notes in his chapter on the monetary base in The New Palgrave that the banking system has virtually never worked in the way hypothesized by the monetary multiplier theory. Instead, central banks have used their powers to effect a desired level of interest rates rather than achieve a pre-determined quantity of monetary base or of some monetary aggregate. He also mentions that the institutional development of the financial markets, notably interbank lending markets, implies that the monetary base multiplier no longer would, or could, work in the textbook fashion. Instead, he argues that the behavioural process leading to a change in monetary bases runs from an initial change in interest rates to a subsequent readjustment in monetary aggregate quantities, endogenously determining these as well as the accommodating monetary base.^[1] Also David Romer notes in his graduate textbook "Advanced Macroeconomics" that it is difficult for central banks to control broad monetary aggregates like M2, causing central banks generally to assign the behaviour of the money supply an unimportant role in policy, focusing instead on adjusting nominal interest rates to stabilize the economy.^[22] Gregory Mankiw, author of one of the widely read intermediate textbooks (Macroeconomics) that present the money multiplier theory, notes in its 11th edition that even though the Federal Reserve can influence the money supply, it cannot control it fully because households' decisions and banks' discretion in the conduct of their business may change the money supply in ways unanticipated by the central bank.^[2]

After the financial crisis, several central banks, including the Federal Reserve,^[6] Bank of England,^[23] Deutsche Bundesbank,^[24] the Hungarian National Bank^[15] and Danmarks Nationalbank^[25] have issued explanations of money creation supporting the view that central banks generally do not control the creation of money, nor do they try to, though their interest rate-setting monetary policies naturally affect the amount of loans and deposits that commercial banks create. The Federal Reserve in 2021 launched several educational resources to facilitate teaching the conduct of current monetary policy, recommending teachers to avoid relying on the money multiplier concept, which was described as obsolete and unusable.^[26][21][27]

Jaromir Benes and Michael Kumhof of the IMF Research Department, argue that: the “deposit multiplier“ of the undergraduate economics textbook, where monetary aggregates are created at the initiative of the central bank, through an initial injection of high-powered money into the banking system that gets multiplied through bank lending, turns the actual operation of the monetary transmission mechanism on its head. At all times, when banks ask for reserves, the central bank obliges. According to this model, reserves therefore impose no constraint and the deposit multiplier is therefore a myth. The authors therefore argue that private banks are almost fully in control of the money creation process.^[28]

Besides the mainstream questioning of the usefulness of the money multiplier theory, the rejection of this theory has also been a theme in the heterodox post-Keynesian school of economic thought.^[21]

Table

This re-lending process (assuming that no currency is used) can be depicted as follows, assuming a 20% reserve ratio and a $100 initial deposit:

Note that no matter how many times the smaller and smaller amounts of money are re-lended, the legal reserve requirement is never exceeded - because that would be illegal.