The Free Market Center
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.
An increase in the number of dollars held as reserves, whether in the bank vault or at the Federal Reserve Bank, does not simultaneously increase the quantity of “money.” The reserve ratio requirement regulates the number of money-dollars (M-dollars) banks may create.
I will discuss reserve ratio requirements and money creation by banks under five different scenarios:
I want to reiterate that dollars cannot be reserves and money simultaneously.
If the reserve ratio 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.
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.
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 System requires member banks to keep on deposits at The Fed or in the bank’s vaults. If, for example, the Fed sets the reserve ratio 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.
If the bank reserve ratio requirements were 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 a Federal Reserve Bank.
With a 50% reserve ratio requirement, banks could create an additional M-dollar with which they could buy additional authorized 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.
If the reserve ratio 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 ratio requirement drops to 10%.
With a 10% reserve ratio requirement, for every $10 they created, banks could pay an additional 9 M-dollars for other suitable assets.
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 ratio 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.
Hypothetically, after this increase in bank reserves, banks could have increased the level of their assets manifold. That did not happen.
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.)
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 ratio 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 zero reserve ratio 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.
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 ratio requirement lowers, the capability of banks to create money-dollars (M-dollars.) Over the years, because of the steadily declining reserve ratio 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.
Proceed to the Presentation describing the relationship between bank reserves and bank account balances.
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