Fractional-Reserve Banking and Money Creation

According to traditional economics textbooks, the current monetary system amplifies initial monetary injections of money. The popular story goes as follows: if the central bank injects $1 billion into the economy, and banks have to hold 10% in reserve against their deposits, this will allow the first bank to lend 90% of this $1 billion. The $900 million in turn will end up with the second bank, which will lend 90% of the $900 million. The $810 million will end up with a third bank, which in turn will lend out 90% 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 monetary pumping of $1 billion, which in turn banks have expanded to $10 billion.
But in a world where central banks don’t target money supply but rather set targets for the overnight interest rate (e.g. the federal funds rate in the United States and the call rate in Japan) does this continue to make sense? Additionally, in some economies like Australia banks are not even compelled to hold reserves against their deposits. Surely then the entire multiplier model in the economics textbooks must be suspect.

This post was published at Ludwig von Mises Institute on June 17, 2017.

 

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