The Money Multiplier – Myth or Reality?

According to much popular economics, the current monetary system amplifies the initial monetary injections of money. Thus, if the central bank injects $1 billion into the economy, and banks hold 10 percent in reserves against deposits, this will allow the first bank to lend 90 percent of the $1 billion. The $900 million, in turn, will end up with the second bank, which will lend 90 percent of the $900 million. The $810 million will end up with a third bank, which, in turn, will lend out 90 percent of $810 million, and so on.

Consequently, the initial injection of $1 billion will become $10 billion (i.e., money supply will expand by a multiple of 10). Note that, in this example, the central bank has actively initiated the monetary pumping of $1 billion, which, in turn, banks have expanded to $10 billion.

Economists from the Post-Keynesian school of economics (PK) have expressed doubt about the validity of the popular framework of the money multiplier. They argue that the key source of money expansion is the demand for loans together with the willingness of banks to lend. Furthermore, for the PK’s, the central banks are not actively engaged in the expansion of money. The role of the central bank in the modern banking system is to perform a balancing act. For instance, if on a particular day the government’s intake of cash exceeds outlays this leads to a deficiency of cash on the day. To prevent a scramble for cash in the money market and a subsequent increase in the overnight interest rate, the central bank must inject an appropriate amount of cash in order to keep the interest rate at the target, or so it is held by the PK’s. In this way of thinking the key source of monetary expansion is commercial banks that—via an increase in lending—set an increase in the money supply.

The supply of loans, according to the PK’s, is never independent of demand—banks supply loans only because someone is willing to borrow the bank’s money by issuing an IOU to a bank. Again, according to this way of thinking, the driving force of bank credit expansion, and thus money supply expansion, is the increase in demand for loans.

According to the PK’s, banks will always be happy to oblige the demand of a good quality borrower. But, if this is so, how is the demand for credit accommodated? What is the source of the supply of credit? It seems that, by the PK’s, the source of the supply is borrowing by banks.

When a bank borrows from another entity all that we will have here is a shift of money from the entity to the bank with no change in the money supply. Also, according to the PK’s, the central bank has nothing to do with the expansion of money supply. So, if neither the central bank nor the borrowings by the banks are causing the money supply expansion, what then causes the increase in the money supply?

Is the Money Multiplier Myth or Reality?

The money multiplier arises because banks are legally permitted to use money, which was placed by individuals in demand deposits. Banks treat this type of money as if it was loaned to them.

If John places $100 in demand deposit at Bank One, he doesn’t relinquish his claim over the deposited $100. He has an unlimited claim against the $100. The demand deposit would not be regarded as different from the money held in the individual’s pocket. (Note that John can exercise his demand for money by either holding money in his pocket, or under the mattress, or in the bank demand deposit). Hence, when the Bank One uses the deposited money as if it were loaned to the bank, it is as if the bank took some of the money from the individual’s possession without the individual’s consent. Once the bank lends some of the deposited money, the bank generates new deposits.

The fact that banks make use of the money placed in the demand deposits, while the holders of these deposits did not relinquish their claims over the deposited money, this sets in motion the money multiplier in the way the popular way of thinking describes. For instance, the Bank One lends $1,000, which was taken from the John’s demand deposit without John’s consent. The $1,000 ends up with Bank Two, which lends, say, 90 percent of the new money. The $900, in turn, ends up with the third bank and so on.

Free Market Minimization

In a free market economy, the likelihood that banks will make use of depositors’ money in their lending activities without the owners’ consent will tend to be very low. For instance, if Bank One makes a loan of $50 to Mike out of the $100 deposited by John, it runs the risk of going bankrupt. Let us say that John buys goods for $100 from Tom, while Mike buys goods for $50 from Jerry. Both John and Mike pay for the goods with checks against their deposits with Bank One.

Now, Tom and Jerry are depositing the received checks from John and Mike with their bank—Bank B—which is a competitor of Bank One. Bank B presents these checks to Bank One and demands cash in return. However, Bank One has only $100 in cash—he is short of $50. Consequently, Bank One runs the risk of being declared bankrupt. The fact that banks must clear checks will be a deterrent against using depositors’ money without the depositors’ consent.

Furthermore, it must be realized that the tendency of being “caught” practicing lending without the depositors’ consent will increase when there are many competitive banks. As the number of banks increases and the number of clients per bank declines, the chances that clients will spend money on goods of individuals that are banking with other banks will increase. This, in turn, is likely to increase the risk of the bank not being able to clear its checks once this bank practices fractional-reserve banking.

Conversely, as the number of competitive banks diminishes, that is, as the number of clients per bank increases, the likelihood of being “caught” practicing lending without depositors’ consent diminishes. In the extreme case, when there is only one bank, it can practice lending without depositors’ consent without any fear of being exposed. Thus, if Tom and Jerry are also the clients of Bank One, then once they deposit their received checks from John and Mike, the ownership of deposits is transferred from John and Mike to Tom and Jerry. This transfer, however, will not produce any disruptive effect on Bank One.

We can thus conclude that, in a free market, if a particular bank tries to expand credit by the use of depositors’ money without their consent, this bank runs the risk of being caught. Hence, in a free-market economy, the threat of bankruptcy is likely to reduce to a minimum the use of deposits in banks’ lending activities without the depositor’s agreement.

While in a free-market economy the use of deposits without the depositors’ consent in banks’ lending would tend to be minimal, this is not so in the framework of the central bank. By means of inflationary monetary injections, the central bank makes sure that the banking system is “liquid enough” so that banks will not bankrupt each other.

Conclusions 

Contrary to Post-Keynesian (PK), the existence of the central bank enables banks to utilize deposits in lending without the depositor’s consent. This sets in motion the money multiplier (i.e., the generation of the money out of “thin air”).