[rolypolyman]

Hi there -- my first post... I have been slogging through books trying to grasp economics. My wife is a regular here and said there was a good economics forum, so I figure I've got nothing to lose..

Anyhow I am trying to understand the money multiplier, which makes no sense. I tried posting about this yesterday on ask.metafilter but the answers were mostly unclear or erroneous.

OK, here's the problem -- all the textbooks I have say that when the Fed creates money, about 7 to 8 times what the Fed puts in gets created. This is what they refer to as the money multiplier.

The explanation I've read says that (assuming 10% reserve, and assuming all banks start with $0), the Fed buys bonds from Bank A and pays them, let's say $1000. The bank keeps $100 and has $900 to loan out. Bank B borrows the $900; it keeps $90 on reserve and has $810 to loan out. Bank C borrows $810, keeps $81 on reserve and has $729 to loan out. Bank D borrows the $729, keeps $72.90 on reserve and has $656.10 to loan out, ad infinitum.

Now my textbooks say that if you add up all that loaned money it adds $810+729+656.10+... and somehow the $1000 actually equals $7000 or so of new money. However all I see is the original $1000 divided into smaller and smaller bits. Bank C, for example, is all tapped out because the amount it had was borrowed. There's no money for it to loan, and it can't touch the $81 in reserve.

So it looks like all we did is divide the $1000. The Fed gave the banks an apple pie, and each bank cut a tiny slice for themself and passed the remainder on to other banks. It adds up to one pie.

What am I missing here? Thanks.

[nero]

Hi, I'll have a go,

I think it would be clearer if we change the identity of the bond seller to person A. This doesn't change anything but it helps keep things clear if we name all borrowers "people" and all lenders "banks".

Person A receives a $1000 from the fed and deposits it in bank A.
bank A can then lend $900 to person B
Person B can then deposit $900 in bank C
banks C can then lend $810 to person C
......
And so it goes on and on.

The key point is that if you add up all the deposits it adds up to $7000. When the bank lends out your deposit , it doesn't notify you in any way, you still think that money is in the bank available for you to withdraw at any time. Yes the banks don't actually have that money available to give to the deposit holders at any particular instant in time, but the deposit holders treat their deposits like it is actually "money in the bank" and therefore in a very real sense the deposit is a "money equivalent". The illusion in this case is more important than the reality. What people want to measure is not how much real currency is in circulation but how much money there seems to be in circulation.

[gego]

I think the way it works is that when the fed buys an asset from a local bank, they do so by funding that local bank's account with the fed by adding $1,000 to it out of thin air (bookkeeping entry). This bank account is the liability of the fed and the asset of the local bank. That local bank's account with the fed is what they use to meet reserve requirements and to cover clearing of checks drawn against them.

If the rule is that the local bank can have loans of $10,000 outstanding if they have a $1,000 reserve on deposit with their bank account with the fed, and IF check clearing were not a concern then that original bank could immediately create out of thin air customer checking accounts equal to $10,000 by accepting notes from customers equal to $10,000. However, the local bank does need to concern itself that it must cover clearing of checks drawn against them by other banks. If the $10,000 newly created checking account is used by a customer to write a check to another customer of the bank then the bank does not have an immediate clearing problem; it just makes a bookkeeping entry to transfer $10,000 from one of its customers checking accounts to another. If, on the other hand the customer borrowing $10,000 writes a check to the customer of another bank then it must have $10,000 on deposit with the fed to cover the clearing of the check.

As a practical matter the local bank knows on the average how much of newly created checking accounts leave their bank and how much never does, so they may be concervative and only create somewhere around $900 of new loans. Remember that reserves are moving all over the place between banks depending who is writing a check to whom, so that when the second bank gets the $900 some of it might eventually come back to the original local bank or it may go to a third bank. The $1,000 reserve stays in the banking system, and is the reserve of some local bank or a combination of them. So eventually as the reserve from the original $1,000 gets spread throughout the banking system so widely that clearing is not a problem, then eventually there will be $10,000 of new money (checking accounts) created by local banks against this $1,000 that the fed created and carries on its books as checking account liability. The nature of the system is for injections of reserves to have a delayed effect on the ultimate money supply increase, so the multiplier is not instant but gradual. How fast this happens depends on the velocity of money, i.e., how fast people spend and borrow.

It think your confusion is that you think the local banks loan out only the original $1,000. What they loan out is newly created checking accounts at their bank based on how much of the $1,000 reserve they own. Additional confusion comes from the way the $1,000 must be used to cover clearing of checks between banks and that until the $1,000 gets spread out among enough local banks they cannot reach full multiplication of the original $1,000 into a full $10,000.

Just remember that for the banking system as a whole banks do not make good on checking accounts because the checking accounts can only be paid by bank credit, whether that bank credit is in the form of federal reserve notes (currency), checking accounts or saving accounts. Collectively, bank customers can only be paid by substituting one form of bank credit for another. This is why eventually bank customers will be left holding an empty bag and why at times of banking crises people give up bank credit in favor of real things like gold and other tangible assets, but this just means that some individuals don't lose and some others take all the loss when the system fails.

This is a corrupt system because it gives the bankers the ability to charge interest on loans that are associated with increases in the money supply. It is corrupt because it depreciates the value of money by increasing the supply; otherwise you could still buy a house for $5,000 instead of $300,000. It is corrupt because it has a built in problem that eventually results in depressions, said depression being in proportion to the size and length of the credit expansion that preceded it.

[gego]

I misstated that a local bank keeps reserves against loans outstanding.

The correctios is that they must keep reserves against their checking and savings accounts outstanding.

[jaws]

The textbook definition of money actually confuses money and credit. See when the fed creates 1000$, it creates 1000$ and nothing more. If it deposits this money into the private banking system, these banks will try to loan out as much as they possibly can without putting their reserves at risk. They may loan out 900$ and keep 100$ on their reserves (a reserve ratio of 10%), or any other number they feel comfortable with. That credit generally gets deposited right back into the banking system, so they can make more loans. They don't actually have a 'multiplier' they are bound to. They can lend out as much credit as they want without any legal limit, except they have to make sure they always have enough cash reserves to meet withdrawals from the loans they made. If they don't they have to borrow cash from the Fed, and that cuts into their profits.

[MrBill]

$this->bbcode_second_pass_quote('nero', 'H')i, I'll have a go,

I think it would be clearer if we change the identity of the bond seller to person A. This doesn't change anything but it helps keep things clear if we name all borrowers "people" and all lenders "banks".

Person A receives a $1000 from the fed and deposits it in bank A.
bank A can then lend $900 to person B
Person B can then deposit $900 in bank C
banks C can then lend $810 to person C
......
And so it goes on and on.

The key point is that if you add up all the deposits it adds up to $7000. When the bank lends out your deposit , it doesn't notify you in any way, you still think that money is in the bank available for you to withdraw at any time. Yes the banks don't actually have that money available to give to the deposit holders at any particular instant in time, but the deposit holders treat their deposits like it is actually "money in the bank" and therefore in a very real sense the deposit is a "money equivalent". The illusion in this case is more important than the reality. What people want to measure is not how much real currency is in circulation but how much money there seems to be in circulation.

[bobbyald]

I haven't read all the answers above but the simple answer is this:

When the FED creates $1,000 then all the other banks are allowed to create money as well ($6,000 in your example).
Yes they just create it out of thin air like magic.

It seems strange to a newbie that banks can create money by simply writing a number in a book but they can.
The only restriction is that they need to hold a certain % of their assets ("real" plus created) in "real" money.
If this % is say, 5%, then the FED creating $1,000 would allow banks to create an additional $19,000.
Lower the reserve % to 2% and banks could create an additional $49,000.

This whole process is referred to as "Fractional Reserve Banking".

How would you like to own a bank then?

[CARVER]

It can also reverse when people start to pay off the loans. Then they walk this path in the other direction and all that created money disappears.

But what happens when people were to suddenly recollect their deposits and stuff it under the mattress (well, put it in a vault)? So what happens when they suddenly decide to take a load of money out of circulation?

[MacG]

The 10% reserve requirement is a textbook example, and only applied to checking accounts under the Basel agreement. Basel II transform everything to "risk management", including the valuation of collaterals. The real reserves for US banks was less than one percent some year ago. One of the very ideas with having a central bank at all is to prevent "runs on the bank" with thin reserves. The central bank is there to loan money to member banks if they temporarily run out of them.

1% reserve give a multiplier of 100, 0.1% gives 1000.

It's a terrible scam all of it, and it will bring terrible suffering to all people who are depending on money to buy and sell things. Roughly all of us.

[MacG]

$this->bbcode_second_pass_quote('CARVER', 'I')t can also reverse when people start to pay off the loans. Then they walk this path in the other direction and all that created money disappears.

But what happens when people were to suddenly recollect their deposits and stuff it under the mattress (well, put it in a vault)? So what happens when they suddenly decide to take a load of money out of circulation?

[MrBill]

$this->bbcode_second_pass_quote('bobbyald', 'I') haven't read all the answers above but the simple answer is this:

When the FED creates $1,000 then all the other banks are allowed to create money as well ($6,000 in your example).
Yes they just create it out of thin air like magic.

It seems strange to a newbie that banks can create money by simply writing a number in a book but they can.
The only restriction is that they need to hold a certain % of their assets ("real" plus created) in "real" money.
If this % is say, 5%, then the FED creating $1,000 would allow banks to create an additional $19,000.
Lower the reserve % to 2% and banks could create an additional $49,000.

This whole process is referred to as "Fractional Reserve Banking".

How would you like to own a bank then?

[azreal60]

I find it funny that you can make fun of people for their bias and then show yours so blalently.

I agree that alot of people don't know dick about money, myself probably among them, but i can read. And the difference between what you wrote and what everyone else wrote is, well, nothing. Their are language differences, but the actual difference is really just how you look at money. You believe your way is correct, but really what bobbyald and others wrote comes out to Exactly the same thing. Your all talking about the idea that banks hold a reserve of the money that they actually have and are allowed to loan out more than they actually have because they have that reserve.
It's a simple enough concept, the reason he probably has confusion is he is equating banks with people. People are not allowed to pretend they have almost 100 times the money they actually have. Or if they do, it always ends badly.

Banks because they have models and systems to show the past performance of how their monentary system has worked, they do not believe they are risking anything by loaning out more than they actually have. After all, their are all the safegaurds in place, it would take a economic disaster of tremendous proportions to get past, and at that point the government would step in anyway, so why worry?

I realize your going to take issue with that viewpoint, but seriously, that's pretty much how bankers think. I know because i asked one before i wrote this. The problem with the banking system is this. It assumes that the above economic disaster won't ever take place. If the banking system does really truely crash, it does take the government stepping in to fix it. And if the government doesn't have the liquidity to fix the problem, then you are well and truely screwed.

I will say though, that if you don't figure resource depletion into the calculations, the modern banking system does at least have alot of sophistication at predicting how things have gone as long as none of the major variables change. It's when a new variable comes into the system that it becomes alot harder to calculate.

[falser]

$this->bbcode_second_pass_quote('azreal60', 'P')eople are not allowed to pretend they have almost 100 times the money they actually have. Or if they do, it always ends badly.

[MrBill]

$this->bbcode_second_pass_quote('azreal60', 'I') find it funny that you can make fun of people for their bias and then show yours so blalently.

I agree that alot of people don't know dick about money, myself probably among them, but i can read. And the difference between what you wrote and what everyone else wrote is, well, nothing. Their are language differences, but the actual difference is really just how you look at money. You believe your way is correct, but really what bobbyald and others wrote comes out to Exactly the same thing. Your all talking about the idea that banks hold a reserve of the money that they actually have and are allowed to loan out more than they actually have because they have that reserve.
It's a simple enough concept, the reason he probably has confusion is he is equating banks with people. People are not allowed to pretend they have almost 100 times the money they actually have. Or if they do, it always ends badly.

Banks because they have models and systems to show the past performance of how their monentary system has worked, they do not believe they are risking anything by loaning out more than they actually have. After all, their are all the safegaurds in place, it would take a economic disaster of tremendous proportions to get past, and at that point the government would step in anyway, so why worry?

I realize your going to take issue with that viewpoint, but seriously, that's pretty much how bankers think. I know because i asked one before i wrote this. The problem with the banking system is this. It assumes that the above economic disaster won't ever take place. If the banking system does really truely crash, it does take the government stepping in to fix it. And if the government doesn't have the liquidity to fix the problem, then you are well and truely screwed.

I will say though, that if you don't figure resource depletion into the calculations, the modern banking system does at least have alot of sophistication at predicting how things have gone as long as none of the major variables change. It's when a new variable comes into the system that it becomes alot harder to calculate.

[MrBill]

P.S. RE Bankers


So you asked a banker? There are bankers of many stripes each with their own individual specialization. I would seriously like to talk to any banker who pretends to understand all there is to know about finance, capital markets, economics and other related topics. Talk to any two bankers and you're likely to have two different points of view. That is why they may both look at the same data and one decides to buy and one to sell.

It is like me going to a gynecologist to complain about my angina?

[ashurbanipal]

$this->bbcode_second_pass_quote('', 'S')o you asked a banker? There are bankers of many stripes each with their own individual specialization. I would seriously like to talk to any banker who pretends to understand all there is to know about finance, capital markets, economics and other related topics. Talk to any two bankers and you're likely to have two different points of view. That is why they may both look at the same data and one decides to buy and one to sell.

[DoctorDoom]

The multiplier concept is pretty simple, and generally the textbooks give you the simplest possible treatment of it, just to get the concept across. Don't get hung up on the exact reserve %, or that different reserve % might be needed for different types of asset, just focus on the core concept. And that is just as nero described it. If you put $1,000.00 into a bank account, the bank can loan out some fraction of that to someone else. He buys something with it, and then the money eventually goes into another account, where another fraction can be loaned out. As you say, the same $1,000.00 is getting smaller and smaller, however, the sum of all those bank account balances is getting larger and larger. Using 10% (which is often used just to keep the examples simple, and doesn't necessarily reflect the real world), you have $1,000.00, then $1,900.00, then $2,710.00, and so on. You can prove using the algebra of infinite sums that this adds up to a number that is 1/r, where r is the reserve requirement, i.e. with a 10% reserve, the multiplier is 10x, with a 20% reserve, it's 5x, etc.

[dhfenton]

The only thing that I would add to the discussion is that the multiplier effect creates new capital for spending at the same time it creates new liabilites. The net of the multiplier effect is also the net of liability. So one could argue that unless the new liability is creating a means of production that will more than pay off the liability, which is often the case in industrial capital projects, the multiplier requires future growth in order for the economy not to stagnate, and/or collapse under the debt. The infusion of new money into the system is designed to stimulate growth. When the liabilities from this infusion of capital come due, and the system can no longer support growth by any means (i.e. a Peak Oil situation), then the system will collapse. The best example was the great depression,when unwise lending caused the banking system to fail, and growth to stop. Peak Oil is one situation when this could happen again. Given the pervasiveness of debt in our society, it could mean a complete collapse of our monetary and banking systems.

[mattduke]

I'll just add in that money created by the Fed is called "high-power" money. The "multiplied money" system is bookkeeping promises to pay high-power money.

[thuja]

$this->bbcode_second_pass_quote('MrBill', '
')

No the difference is this. I know next to nothing of practical value about resource depletion and the relative merits of one alternative fuel over another. Therefore, I don't go around displaying my ignorance for all the world to see. I read posts on these subjects and try to absorb why for instance we may not be able to switch to a hydrogen economy as easily as I had originally assumed given my limited knowlege of hydrogen? To me it looked like a promising alternative. Many in these forums have pointed out some of its technical flaws. I reserve the right to comment on the economics of a transition though.

What I don't go around doing is saying,

"It is all a sham! The fcuking oil cos. are just trying to keep us dependent on hydrocarbons for as long as possible! The gawddamn Republikans and the Bushies are all in leagues with the Haus of Saud and it's all a big conspiracy. WTSHTF we're all scru'd 'cuz the rich want to turn us all into their slaves. They've programmed us to consume more than we earn so that tey keep us a virtual serfs tied to our homes thru mortgages handed out at cheap ARMs so that we would buy more haus than we cud afford. Itz tru 'cuz I read it on financialsense.com and those guys know what a scam it really is not like the corporate controlled media. The bloggoshpere is the only tryu source of real information anyhoo. Go Kunstler!"

So yes, I have patiently corrected many naive and some patently wrong postings, but have also answered a lot of honest questions. But my fascade is starting to slip because it is like trying to combat a forest fire of misinformation with a bucket of facts.

And so what? Well, for starters Peak Oil is a serious geological issue and sites like this play a role in public awareness. However, the entire movement risks discrediting itself because peak oilers cannot get their facts straight. Therefore who will believe them about peak oil if they go off ranting about things they do not understand? Especially in this post where someone is honestly trying to understand the concept of fractional reserve banking?

Maybe I have no right to be critical, but to be honest there are so many flamers on this site that it risks losing all credibility with people with moderate views. Then it becomes another waste of space. Completely irrelevant to the cause of finding solutions to peak oil.