The Money multiplier trilogy (Part II: Resurrection)

After being killed, it is worthwhile to wonder if the Money multiplier deserves a second chance.

I think it does.

So gather round the Dragon Balls because the Money Multiplier is going to be resurrected.

First things first. Why did the multiplier died, again?

Banks don’t need Reserves to make Loans! Loans create Deposits!


So, do Central Banks supply whatever the amount of reserves Commercial Banks need (to comply with legal requirements, to settle payments or to face cash withdraws) ?

Yes and no.

Yes, in the short run they do. They normally establish a interest rate target, so if they don’t comply with quantity demanded of reserves by Commercial Banks, it would lead to financial havoc as interest rates diverge from their targets.

No, Central Banks have a goal for inflation (or NGDP or …) so they must adjust their intermediate target for interest rates in a way they can achieve their ultimate goal.

So, it’s true to say both Reserves and Interest Rates are endogenous, a trustworthy central bank will only set its ultimate goal as exogenous.

Even though a Commercial Bank is not (usually) reserve constrained, as it can look for reserves in the inter-bank market, or can go to the Central Bank (either by discount or overdraft), it faces uncertainty towards the future.

Uncertainty about the “loyalness” of its depositors, uncertainty about the demand for cash, uncertainty about the demand for non-bank assets. A bank must face the uncertainty of its “usual business” liability side (Deposits) with both the “unconventional” liability side  (Central Bank lending) and the liquidity of its Asset side of the balance sheet.

Banks face restrictions. They don’t possess a widow’s cruse.

The Central Bank creates some of those restrictions. The competition among financial assets create some of those restrictions. The Economy creates some of those restrictions.

My goal is to combine the three theories of banking in a unified one (credit creation theory, Money multiplier, financial intermediary). I believe they must be all the same.

Those 3 theories can be matched with the 3 restrictions stated above. The 3 theories are all different angles of the same reality.

Banks create Money through credit. Yes.

The Central Bank influences the credit creation by supplying Reserves. Yes.

Banks are in the end of the day, just financial intermediaries. Yes.

My next post will try to create a comprehensive model which puts together the 3 theories, which in my view (with some assumptions) will grant a simplified but general view of how Banking and Central Banking works.

Let´s try to give the multiplier, Immortality.

(and create another multiplier during the process)


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