No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Eleven: Money, Money, Money! 267 We now have $1,000 + $900 + $810, or $2,710 in checking accounts. But we are not done yet. This process can just keep going and going, with the next loan being for $729 (90% of $810), then $656.10, then $590.49, etc. At each one of these banking steps, additional money is being created when money is loaned out and, therefore, additional purchasing power. But this new additional purchasing power comes without an increase in real goods and services. The fact that investments made based on these loans may provide additional goods and services in the future does not help with inflation today. When new money chases the existing stock of goods and services, prices will rise. So how much new money was created? Well, as the banking system creates an overall level of new money with additional reserves, we can define the money multiplier as the ratio of the money supply to the monetary base (or high powered money). Theoretically, this multiplier can be as high as the inverse of the required reserve ratio, or 10 (reciprocal of 10%, or 1/10). So if an initial increase in Federal Reserve high powered base money is $1,000, then it will support (potentially) up to $10,000 of new money, as seen in Figure 11.12 . Hopefully you can see why we call the monetary base “high powered money.” Banking system reserves Money multiplier: the ratio of the money supply to the monetary base. +$810 +$810 Checking Account Reserves Assets Liabilities Bank of Wisconsin Figure 11.11, Bank of Wisconsin T-Account. When Miller Welding cashes Steve’s check with their bank, the Bank of Wisconsin, the bank’s reserves and liabilities both increase the same amount, in this case $810. Figure 11.12, Summary of Multiple Deposit Expansion Process. After the Federal Reserve initially increases reserves by $1000 (in this case by purchasing $1000 of securities from Bank of USA), Bank USA finds itself with $1000 of reserves that don’t return very much, so it is profitable to loan it out. This $1000 will be spent into the economy and may end up deposited at the Bank of Narnia. Since BoN has to keep 10% of reserves, they only loan out $900, keeping $100 as required reserves. As that loan money is spent into the economy, it may end up at Bank of Texas as deposits. BoT will likewise loan out as much as they can ($810), keeping $90 as required reserves. This process continues to BoW and to the next bank and the next. If this process continues to its limit, we will see that an initial increase in reserves of $1000 by the Federal Reserve will create $10000 in new money. This is what is meant when people say that the Fed creates money “out of thin air“. Multiple Deposit Expansion: Initial Federal Reserve Increase of $1000 in Banking System Reserves Bank Increase in Deposits ($) Increase in Loans ($) Increase in Reserves ($) Bank of USA 0 1000 0 Bank of Narnia 1000 900 100 Bank of Texas 900 810 90 Bank of Wisconsin 810 729 81 Next Bank 729 656.10 72.9 Total 10000 10000 1000 And the process keeps going ...