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Money Multiplier is Really About Credit Out of “Thin Air”

According to traditional economics textbooks, the current monetary system amplifies the initial monetary injections of money. The popular story goes as follows: if the central bank injects $1 billion into the economy and banks have to hold 10% in reserve against their deposits the initial injection of $1 billion will become $10 billion i.e. money supply will expand by a multiple of 10. Note that in this example the central bank has actively initiated monetary pumping of $1 billion, which in turn banks have amplified to $10 billion.

Economists from the post-Keynesian school of economics (PK) have expressed doubt about the validity of this popular framework of thinking[1]. One of the advocates of this school, Bill Mitchell, in an article on his blog – Money Multiplier and other Myths – wrote that,

It (money multiplier) is also not even a slightly accurate depiction of the way banks operate in a modern monetary economy characterised by a fiat currency and a flexible exchange rate. In the present monetary framework, it is held the job of the central bank is to ensure that the level of cash in the money market is in tune with the interest rate target.

According to Mitchell,

The way banks actually operate is to seek to attract credit-worthy customers to which they can loan funds to and thereby make profit.

Furthermore, according to Mitchell,

So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.

…click on the above link to read the rest of the article…

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