The money multiplier model described in economics textbooks is outdated and incorrect because of three false assumptions:
- That a bank needs deposits before it can make a loan.
- That the Government can control the amount of money created by the banking sector by altering the reserve ratio and amount of ‘base money’ in circulation.
- The amount of money created by banks is mathematically limited (based on the previous 2 assumptions).
Point 1 is really crucial because this leads to all kinds of misunderstandings. Under the current system, banks don’t work as middlemen between savers and borrowers and do not need deposits before they make a loan. The Bank of England has addressed this misconception here.
Charles Goodhart said over 20 years ago that the Money Multiplier is “such an incomplete way of describing the process of the determination of the stock of money that it amounts to mis-instruction”. Our Banking 101 course covers the problems with the money multiplier model. For empirical evidence see this paper by the Fed, or this one for the UK.
The term ‘fractional reserve banking’ is also confusing, because it is used quite freely to describe different things. Some people might say that fractional reserve banking is based on this money multiplier model, where banks retain a percentage of their deposits as reserves. This model doesn’t exist in reality, therefore banks are no longer operating under a fractional reserve banking system. However other people might say if banks are only able to repay a fraction of their depositors at any time, then this is ‘fractional reserve banking’, so we still have a fractional reserve system. Welcome to the world of money and banking, where one phrase can mean multiple things! It’s always best to clarify what the person means before responding!
Posted in: 2. The Current Monetary System