A very simple question that to most people is obviously true. But is it?
The story in most introductory economics textbooks goes something as follows:
- Bank A receives a deposit of £1000
- With a reserve requirement of 10%, the bank keeps £100 in its reserves and can lend out £900.
- This can be used to pay an account in Bank B and the same process occurs.
A quick spreadsheet for an initial deposit of £1000 with a 10% reserve requirement and a minimum loan size of £100 shows the total loans:
Now a bank can aggregate deposits from different accounts and so carry on the loan process even with a minimum loan set to £100. The end result is that the original £1000 ends up in the banks (taken together) reserve accounts at the Central Bank and that £10,000 has been loaned out. This is the Money Multiplier – with a 10% reserve requirement money has been multiplied by 10.
It is important to note that no new money is created, rather it is the same money that has been circulating from deposit to loan with each bank retaining 10% of that deposit each time. (Of course, any bank could be involved in the deposit loan process multiple times, indeed it could even always be the same bank).
The argument is meant to be a demonstration of what is known as the Loanable Funds Doctrine within neo-classical mainstream macroeconomics, which implies that bank are just financial intermediaries, banks lend deposits, merely matching patient savers with impatient borrowers and, as such, can be left out of their models of the macro economy – the study of the economics of nations. They might be added in as a friction – the cost of doing business – as this service has transaction costs to the loans process (otherwise how would the banks generate profits), but they are not intrinsic to their models.
So when the Queen asked economists how they missed the Global Financial Crisis (GFC), part of the answer is because of believing the above, justified them in not modelling a key part of the financial markets and so they missed the signficant effect these had on the real economy.
In the next post I will show this is not how banks make loans and how they do.
Some concluding remarks on issues that should be discussed if the above were true but are rarely if ever discussed.
Clearly it takes time for the deposit-loan-redeposit process to occur. The above process was shown 34 times to get from an initial deposit of £1000 down to £100. Even allowing for aggregation across accounts, the velocity of this process needs to taken into account in deriving the money multiplier but I never see such a point being made. That point also leads to the Monetarist’s favourite Quantity of Money theory, but there they assume that this velocity is constant and quite low. (I will not explore this theme more for now, I have bigger fish to fry).
Another point that follows from the velocity issue is that the fractional reserve could be a policy parameter available to the Central Bank. For example, changing the reserve requirement from 10% to 5% could be a form of private sector stimulation, as the available loans at each stage would be 5% larger and so available sooner in having an effect on demand in the economy. Again I do not see this being discussed in such a way. (Of course, the original argument for a reserve requirement was to ensure banks were liquid enough to avoid bank runs but there are, as we shall see, other means of managing liquidity).
Thats all for now.
 I would be grateful anyone has any references to textbooks that don’t commit this error to add these in the comments, I have not yet found any within the mainstream economics approach.