The conventional model: the “Money Multiplier”
- Banks are required to retain a certain percentage of any deposit as a reserve, known as the “reserve requirement”; for simplicity, let’s say this fraction is 10%.
- When customer Sue deposits say 100 newly printed government $10 notes at her bank, it is then obliged to hang on to ten of them—or $100—but it is allowed to lend out the rest.
- The bank then lends $900 to its customer Fred, who then deposits it in his bank—which is now required to hang on to 9 of the bills—or $90—and can lend out the rest. It then lends $810 to its customer Kim.
- Kim then deposits this $810 in her bank. It keeps $81 of the deposit, and lends the remaining $729 to its customer Kevin.
- And on this iterative process goes.
- Over time, a total of $10,000 in money is created—consisting of the original $1,000 injection of government money plus $9,000 in credit money—as well as $9,000 in total debts. The following table illustrates this, on the assumption that the time lag between a bank receiving a new deposit, making a loan, and the recipient of the loan depositing them in other banks is a mere one week.
The Data versus the Money Multiplier ModelTwo hypotheses about the nature of money can be derived from the money multiplier model:
- refuse to issue new reserves and cause a credit crunch;
- create new reserves; or
- relax the reserve ratio.
How to be a “Cavalier of Credit”Note Bernanke’s assumption (highlighted above) in his argument that printing money would always ultimately cause inflation: “under a fiat money system“. The point made by endogenous money theorists is that we don’t live in a fiat-money system, but in a credit-money system which has had a relatively small and subservient fiat money system tacked onto it.
How the Cavaliers “Make Money”
- If the rate of money creation is higher (this is by far the most important factor);
- If the rate of circulation of unlent reserves is higher; and
- If the rate of debt repayment is lower—which is why, in “normal” financial circumstances, banks are quite happy not to have debt repaid.