The Banking System Can’t Lend Out Reserves, But a Bank Can – Ludwig von Mises Institute Canada.
This post will seem simple to some, but I want to correct a slight confusion I’ve seen over the last several years in the economics blogosphere. (I was motivated to write because of an exchange with Nick Freiling, who loves the Austrian School but thought I had made a basic mistake in a recent piece I wrote about the Federal Reserve’s policies.) Specifically, Freiling and many others have challenged the standard claim that commercial banks lend out reserves when they make loans to customers. The critics argue that since the public will generally end up depositing their checks with their own respective banks, the granting of loans will merely rearrange which banks hold certain levels of reserves, but the banking system as a whole can’t “lend them out” because there would be nowhere for them to go. Hence, the critics allege, the talk of the Fed (say) raising the interest rate that it pays on reserves in order to discourage lending is nonsense; in Freiling’s words, there is (allegedly) no tradeoff between loans and reserves.
This argument from the critics is wrong. It rests on a confusion between micro-incentives and system-wide outcomes. In particular, the interest rate that the Fed pays on reserves can most definitely affect the willingness of commercial banks to make loans on the margin.
Before jumping directly into the issue, let me start with an analogy with actual currency held in people’s wallets or purses. (I see Nick Rowe thought of the same analogy last summer.) Forget about banks. Suppose there are $100 billion in actual currency in the economy, held by a population of 100 million people, and that this is the only money that these people use. That means on average each person holds $1,000 in currency.
