The following comes from an excellent new paper from the Fed.  The paper describes the myth of the money multiplier and is an absolute must read for anyone who is trying to fully understand the current environment.  It turns much of textbook economics on its head and describes in large part why the bank rescue plan and the idea of banks being reserve constrained is entirely wrong:

“The role of reserves and money in macroeconomics has a long history.  Simple textbook treatments of the money multiplier give the quantity of bank reserves a causal role in determining the quantity of money and bank lending and thus the transmission mechanism of monetary policy.  This role results from the assumptions that reserve requirements generate a direct and tight linkage between money and reserves and that the central bank controls the money supply by adjusting the quantity of reserves through open market operations.  Using data from recent decades, we have demonstrated that this simple textbook link is implausible in the United States for a number of reasons. First, when money is measured as M2, only a small portion of it is reservable and thus only a small portion is linked to the level of reserve balances the Fed provides through open market operations.  Second, except for a brief period in the early 1980s, the Fed has traditionally aimed to control the federal funds rate rather than the quantity of reserves.  Third, reserve balances are not identical to required reserves, and the federal funds rate is the interest rate in the market for all reserve balances, not just required reserves.  Reserve balances are supplied elastically at the target funds rate.  Finally, reservable liabilities fund only a small fraction of bank lending and the evidence suggests that they are not the marginal source data for the most liquid and well-capitalized banks.  Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected.  Specifically, our results indicate that bank loan supply does not respond to changes in monetary policy through a bank lending channel, no matter how we group the banks.

Our evidence against the bank lending channel at the aggregate level is consistent with other recent studies such as Black, Hancock, and Passmore (2007), who reach a similar conclusion about the limited scope of the bank lending channel in the United States, and Cetorelli and Goldberg (2008), who point out the importance of globalization as a way to insulate the banks from domestic monetary policy shocks.  Our findings are also consistent with the predictions of Bernanke and Gertler (1995) from over a decade ago that the importance of the traditional bank lending channel would likely diminish over time as depository institutions gained easier access to external funding.

Our evidence against the bank lending channel at the micro level is consistent with Oliner and Rudebusch (1995), but it contrasts previous findings of a lending channel for small, illiquid, or undercapitalized banks (see Kashyap and Stein (2000), Kishan and Opiela, (2000) and Jayartne and Morgan (2000)).  What is common in all these studies is that their sample periods cover the period prior to 1995, when reservable deposits constituted the largest source of funding.  As we have shown in Table 3, this is no longer a feature that characterizes bank balance sheets in the post-1994 period.  Furthermore, Kashyap and Stein (2000) and Kishan and Opiela (2000) interpret a change in the sensitivity of bank lending to monetary policy as evidence of a bank lending channel.  We argue that changes in the sensitivity of bank loans may of funding, either.  All of these points are a reflection of the institutional structure of the U.S. banking system and suggest that the textbook role of money is not operative. While the institutional facts alone provide compelling support for our view, we also demonstrate empirically that the relationships implied by the money multiplier do not exist in the stem from the demand side, and that a better test for the lending channel is to check whether bank loans are financed by reservable deposits.  Our findings suggest that this is not the case.

In general, our results echo Romer and Romer (1990)’s version of the Modigliani-Miller theorem for banking firms.  They argue that banks are indifferent between reservable deposits and non-reservable deposits.  Hence, shocks to reservable deposits do not affect their lending decisions, and changes to reserves only serve to alter the mix of reservable and non-reservable deposits.  Our findings in this paper support the argument that shocks to reservable deposits do not change banks’ lending decisions.

Since 2008, the Federal Reserve has supplied an enormous quantity of reserve balances relative to historical levels as a result of a set of nontraditional policy actions.  These actions were taken to stabilize short-term funding markets and to provide additional monetary policy stimulus at a time when the federal funds rate was at its effective lower bound.  The question arises whether or not this unprecedented rise in reserve balances ought to lead to a sharp rise in money and lending.  The results in this paper suggest that the quantity of reserve balances itself is not likely to trigger a rapid increase in lending.  To be sure, the low level of interest rates could stimulate demand for loans and lead to increased lending, but the narrow, textbook money multiplier does not appear to be a useful means of assessing the implications of monetary policy for future money growth or bank lending.” (emphasis added)

Someone with Ben Bernanke and James Bullard’s email addresses might want to forward this along to them before they go talking up their supposed “silver bullet” of quantitative easing without realizing that it is unlikely to meet its desired goals.


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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • Willy2

    Did it take you this long to realize that the “”money multiplier”” was bogus ? Steve Keen debunked that myth already in late 2009 in a video on his blog. Although I am not capable of reproducing his thesis, it made much more sense than the M.M. Keen’s theory was called “Money Circuit Theory””.

  • http://pragmaticcaptilist GLH

    I think the question isn’t when TPC realized it, after all he/she has been talking about this for a good while. A more appropriate question is why did it take someone at the FED this long to realize it.

  • F. Beard

    Yep, “reserves” are a red-herring to distract from the fact that banks are counterfeiters that loan out their “money” rather than just spend it into circulation. So the expression “fractional reserve lending” should be abandoned. “Temporary money for debt” is much more accurate and implies the boom-bust cycle too.

    The solution is obvious from a moral perspective; free the debt slaves, compensate the savers, and allow genuine money alternatives to borrowing and lending (common stock for instance). From an amoral perspective, the solution is not obvious at all which explains the confusion.

  • David Merkel

    Now to move onto more economic heresies that are yet true – the multiplier for government stimulus is less than one, so avoid stimulating. 2) Debts must shrink and the financial sector must shrink. Indebted economies are inflexible economies. We need to stop subsidizing debt, and encourage equity finance.

  • Willy2

    I musthave missed it. Well, I think the FED doesn’t want to ackowledge that the MM is bogus because then Congrss can’t favour it’s friends on Wall Street any more.

  • TPC

    EXACTLY! I have been blathering about this for years, but my opinion matters little. For some reason though, when the paper has “FRB” attached to it everyone and their mother pays attention.

  • TK7936

    Wierd my text books knew this in the 90s

  • Anonymous

    One must at least skim the article to appreciate its purpose: Take a well-accepted truism for the last 50 (100?) years–you can pump reserves to little effect on M1 (not to mention M2 inefficacy) since you can lead a banker to reserves but you can’t make him lend–and “prove” it is true with VARs & Granger causality tests. The more painfully obvious the assertion & the more well accepted it is, the greater the rubber-stamping by the VAR methodology et al can be used to sell the methodology itself. By using M2 with its large reserveless component rather than M1 one can, of course, absolutely guarantee that results are “correct,” proving the methodology.

  • TPC

    Yes, it’s nice to get a firm analytical response from a trusted? authority. To many of us, this fact has always been apparent just by understanding how banking really works. If you walk into a bank the branch manager doesn’t check his reserve balance before making loans. They make as many loans as they can sell each day and then find the reserves (hence the lender of last resort). So, from a common sense perspective this has always been obvious to many, but not properly backed by analysis. This paper puts a nice dent in the myth and must have many professors and economists scratching their heads….

  • AWF

    Submitted for your consideration:
    The Money Multiplier is a “Fact”
    Why isn’t the Money Multiplier working Now?
    In a ” Depression” people would rather Hold/Hoard Money!
    In a ” Depression” liquidity is the MOST IMPORTANT concern!
    In a ” Depression” people would rather invest in LT Bonds for safety and return of principle
    In a ” Depression” the “Fear Factor” is more powerfull than the ” Greed Factor”
    Consequently “Money” has a hard time multiplying ” Under the Mattress”

  • spragus

    AKA “pushing on a string” popularized by one JM Keynes.


    Where is MBA on this one? ANGRY MBA had a lot to say about this the other day, where is he?