Money Multiplier is Bullshit

Undergraduate economics commonly teaches that banks take in deposits and lend these out, increasing the money supply. This is wrong. The incorrect depiction of a fractional reserve banking system has caused widespread confusion, with some people thinking of it as a strange conspiracy, and is a staple of paranoid ramblings on Facebook. It is taught that once banks acquire deposits, these deposits are then “multiplied up” by some ratio, called the money multiplier, as they are repeatedly lent out, increasing the money supply:

$$ money multiplier = \frac{1}{Reserve Ratio} $$

This left the conspiracy theorists confused, because it seems like theft. Banks are lying to depositors, saying their money is safe in the vault, when in reality it is being gambled on loans. This must be the work of (deep state, lizard people, Influential minority in finance)! The reality is that deposits are not lent out, and loans create deposits, not the other way around.

If a bank wants to make a loan for $1,000,000 it just makes the money up, it doesn’t need to come from anywhere. After it is loaned out, the money is deposited in an account, creating deposits. Banks don’t look for deposits to loan out, they create money. They can make loans no matter how many deposits they currently have. Banks are not intermediaries that take in deposits and lend these out. They create money.

Because of this, creating loans increases the money supply, and on the other hand replaying loans destroys money. But what limits are there on the amount of money created?

Banks are still heavily constrained in their actions, because they have to be profitable and have to comply with regulation. In addition, because interbank settlement is done using central bank money, banks are constantly looking for ways to get more so they able to transfer to other banks. This happens though attracting deposits to the bank, or borrowing reserves. Central Banks generally control the amount of money in the economy by setting the price of money through interest rates, or in extreme times through quantitive easing.

The money multiplier does get some key ideas right, that banks demand reserves, and that freer access to them can increase loans, but they have it backwards. Loans create deposits, not the other way around.

Rene Bidart
Rene Bidart
PhD Candidate

PhD candidate at University of Waterloo - Deep Learning