The Myth of the Money Multiplier

Everyone who has studied money and banking has been introduced to the concept of the money multiplier. The multiplier is a factor which links a change in the monetary base (reserves + currency) to a change in the money supply. The multiplier tells us what multiple of the monetary base is transformed into the money supply (M = m x MB). Since George Washington's portrait first graced the one dollar bill students have listened to the same explanation of the process. No matter what the legally cash loan required reserve ratio was, the standard example always assumed 10 percent so that the math was simple enough for college professors. What joy must have spread through the entire financial community when, on April 12, 2002, the Fed, for the first time, set the required reserve ratio at the magical 10 percent. Given the simplicity and widespread understanding of the money refinance loans multiplier it is a shame that the myth must be laid to rest.


The truth is the opposite of the textbook model. In the real world banks make loans independent of reserve positions, then during the next accounting period borrow any needed reserves. The imperatives of the accounting system, as previously discussed, require the Fed to lend the banks whatever they need.


Bank managers generally neither know nor care about the aggregate level of reserves in the banking system. Bank lending decisions are affected by the price of reserves, not by reserve positions. If the spread between the rate of return on an asset and the fed funds rate is wide enough, even a bank deficient in reserves will purchase the asset and cover the cash needed by purchasing (borrowing) money in the funds market. This fact is clearly demonstrated by many large banks when they consistently purchase more money in the fed funds market than their entire level of required reserves. These banks would actually have negative reserve levels if not for fed funds purchases i.e. borrowing money to be held as reserves for Cash Advance.

If the Fed wants to increase the money supply, devotees of the money multiplier model, including numerous Nobel Prize winners, would have the Fed purchase securities. When the Fed buys securities reserves are added to the system. However, the money multiplier model fails to recognize that the added reserves in excess of required reserves drive the funds rate to zero since reserve requirements essentially do not change until the following accounting period. That forces the Fed
to sell securities, i.e., drain the excess reserves just added to maintain the funds rate above zero.


If, on the other hand, the Fed wants to decrease money supply, taking reserves out of the system when there are no excess reserves places some banks at risk of not meeting their reserve requirements. The Fed has no choice but to add reserves back into the banking system, to keep the funds rate from going, theoretically, to infinity.


In either case, the money supply remains unchanged by the Fed's action. The multiplier is properly thought of as simply the ratio of the money supply to the monetary base (m = M/MB). Changes in the money supply cause changes in the monetary base, not vice versa. The money multiplier is more accurately thought of as a divisor (MB = M/m).


Failure to recognize the fallacy of the money-multiplier model has led even some of the most well- respected experts astray. The following points should be obvious, but are rarely understood:

1. THE INELASTIC NATURE OF THE DEMAND FOR BANK RESERVES LEAVES THE FED NO CONTROL OVER THE QUANTITY OF MONEY. THE FED CONTROLS ONLY THE PRICE.

2. THE MARKET PARTICIPANTS WHO HAVE A DIRECT AND IMMEDIATE EFFECT ON THE MONEY SUPPLY INCLUDE EVERYONE EXCEPT THE FED.