The Free Market Center
In my preceding article (Reserves Are Not Money), I described why “dollars” cannot act as bank reserves and bank “deposits” at the same time. I based that publication on a 100% reserve requirement in which, although money can be transferred from one bank to the other, banks cannot create new money. In this article, I will discuss the money creation process.
I, again, want to make my meaning of “money” explicit.
“Money” consists of any economic good, or any claim on such a good, that serves as a general medium of indirect exchange and that acts as a final means of payment.
Many people do not seem to understand that use defines money. “Moneyness” does not exist in any good or claim on such a good. That applies to dollars in any form. Dollars held as reserves cannot simultaneously act as money.
This means that an increase in the number of dollars held as reserves, whether in the bank vault or at the Federal Reserve, does not simultaneously increase the quantity of “money.”
I will describe how the reserve requirement regulates the number of money dollars (M-dollars) banks may create and how banks increase the number of money dollars in response to changes in total reserves.
I will discuss reserve requirements and money creation by banks under five different scenarios:
Since this discussion refers to money creation, I will refer only to “demand deposits”( aka transaction accounts.)
Under a fractional reserve banking system, like the one that we have in this country, banks can create new money based on the percentage of reserve dollars (R-dollars) the Federal Reserve bank requires banks to keep on deposit at The Fed. If, for example, the Fed sets the reserve requirement at 50%, banks can create twice as many M-dollars as it has in R-dollars in its account at the Federal Reserve. This relationship should become clearer to you as you read on.
I will use the following model to describe the relationship between reserve dollars (R-dollars) and money dollars (M dollars) under the reserve requirements referred to in the five scenarios listed above. You will see that I move the fulcrum on this model to indicate the reserve requirements.
As the fulcrum moves to the right, the reserve requirement declines, and the amount of money dollars (M-dollars) a bank may create increases.
The following model shows the money-making potential of banks based on reserve requirements and actual reserves. In this case, the fulcrum remains in the middle because a bank’s books must balance, indicating the relative amount of money banks can create under one of the five reserve requirements scenarios.
Having more bank reserves does not mean the banks will automatically create more M-dollars. They will only create more M-dollars if they find suitable assets to buy.
I want to reiterate that dollars cannot be reserves and money simultaneously.
I discussed the scenario of the 100% reserve requirement in my previous article, but I will show it again here for your reference.
If the reserve requirement were 100%, banks could not create additional money. They would be restricted to facilitating market transactions and could not purchase assets based on the amount of demand deposit liabilities.
(The following graphic shows the relationship between the quantity of bank reserves (R-dollars) and the quantity of money dollars (M-dollars) the bank could create based on the quantity of bank reserves (R-dollars) and the required reserve ratio. In the case of 100% reserves the quantity of R-dollars and M-dollars must match.)
As you might expect, bank deposit liabilities would equal the number of reserve dollars. In this scenario, the only asset the bank will hold will be its reserves at the Federal Reserve Bank.
(The following graphic shows the relationship between the quantity of bank reserves (R-dollars) and the quantity of money dollars (M-dollars) the bank could create based on the quantity of bank reserves (R-dollars) and the required reserve ratio. In the case of 100% reserves the quantity of R-dollars and M-dollars must match..)
If the bank reserve requirements were set at 50%, banks would have the capacity to create two money dollars (M dollars) for every reserve dollar (R dollar) they have, whether in their vaults or maintained at the Federal Reserve.
(The following graphic shows the relationship between the quantity of bank reserves (R-dollars) and the quantity of money dollars (M-dollars) the bank could create based on the quantity of bank reserves (R-dollars) and the required reserve ratio. The bank has no obligation to create as many M-dollars as they may have authorization to create.)
With a 50% reserve requirement, banks could create an additional M-dollar with which they could buy additional assets. Those assets would be recorded at the price paid by the bank and would normally consist of debt instruments from public or private entities.
(The following graphic shows quantity of M-dollars the bank creates and the total asset held by the bank (R-dollars plus notes and securities purchased). The bank has no obligation to create as many M-dollars as they may have authorization to create.)
If the reserve requirement were lowered to 10% (the level at which it was set for several years), the bank could create 10 M-dollars for every one R-dollar. You can see that the money-creation potential of a bank is increased tremendously when the reserve requirement drops to 10%.
(The following graphic shows the relationship between the quantity of bank reserves (R-dollars) and the quantity of money dollars (M-dollars) the bank could create based on the quantity of bank reserves (R-dollars) and the required reserve ratio. The bank has no obligation to create as many M-dollars as they may have authorization to create.)
With a 10% reserve requirement, for every $10 they created, banks could pay an additional 9 M-dollars for other suitable assets.
(The following graphic shows quantity of M-dollars the bank creates and the total asset held by the bank (R-dollars plus notes and securities purchased). The bank has no obligation to create as many M-dollars as they may have authorization to create.)
During the financial crisis of 2008, the Federal Reserve, through its open market operations, created reserve dollars (R-dollars) far in excess of the 10% reserve requirement in effect at that time. They increased these reserves by purchasing assets from banks, which replaced some lower-quality assets with R-dollar reserves.
(The following graphic shows the relationship between the quantity of bank reserves (R-dollars) and the quantity of money dollars (M-dollars) the bank could create based on the quantity of bank reserves (R-dollars) and the required reserve ratio. The bank has no obligation to create as many M-dollars as they may have authorization to create.)
Hypothetically, after this increase in bank reserves, banks could have increased the level of their assets manifold. That did not happen.
(The following graphic shows quantity of M-dollars the bank creates and the total asset held by the bank (R-dollars plus notes and securities purchased). The bank has no obligation to create as many M-dollars as they may have authorization to create. In the case of QE banks did not create more M-dollars or buy more assets.)
Many people expected that this would cause a large spike in the quantity of money (M-dollars.) Despite the increased capability of banks to create money dollars (M-dollars) because of the expansion in bank reserves (R-dollars), this did not occur. The total assets for banks remained essentially the same; only the composition changed. Now, instead of notes and bonds, banks owned more reserve dollars.
It has long been my contention that the “QE” was done to shore up bank capital and not, as many people thought, to increase the money supply. Despite the dramatic increase in bank reserve balances, the quantity of money did not make a comparable expansion. (See chart.)
This chart shows the dramatic increase in R-dollars and the modest increase in M-dollars. Figures shown in log scale.
Since the Federal Reserve relinquished its indirect control of bank deposit liabilities during the quantitative easing phase in 2020, it took the unprecedented step of reducing reserve requirements to zero. Hypothetically establishing no limit to the amount of M-dollars that banks could create. (I will discuss in another post what keeps banks from creating unlimited quantities of M-dollars.)
(The following graphic shows the relationship between the quantity of bank reserves (R-dollars) and the quantity of money dollars (M-dollars) the bank could create based on the quantity of bank reserves (R-dollars) and the required reserve ratio of 0%. The bank has no obligation to create as many M-dollars as they may have authorization to create.)
The zero reserve requirement had little effect on the quantity of money dollars.
Only during the government spending for Covid 19 relief did the quantity of money increase significantly.
(The following graphic shows quantity of M-dollars the bank creates and the total asset held by the bank (R-dollars plus notes and securities purchased). The bank has no obligation to create as many M-dollars as they may have authorization to create. In the case of the elimination of the reerve requirement banks did not create more M-dollars or buy more assets.)
I cannot over-emphasize that The Federal Reserve does not create “money.” The Fed only creates reserve dollars (R-dollars). Only banks create money dollars (M-dollars.)
As the reserve requirement lowers, the capability of banks to create money dollars (M-dollars.) Over the years, because of the steadily declining reserve requirements, the influence of The Fed over the creation of money dollars (M-dollars) by banks has also steadily declined.
During the financial crisis in 2008, The Fed increased the level of total reserves to the point of essentially relinquishing its leverage over the creation of M-dollars by banks. Although still a big player in the financial market, they reduced their role to just a player—in spite of rhetoric to the contrary.
Be Careful what you believe about the Fed’s influence in markets and the economy.
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