Complex Money Multiplier - Case Study Example

Money Multiplier Money multiplier is variously referred to as the deposit multiplier or the credit multiplier. According to Fullwiler (2007) it measures the extent to which money creation in the banking system will cause money supply growth to exceed monetary base growth. The multiplier refers to the multiple by which money supply expansion is greater than the rise in the monetary-base. This means that if the multiplier is 8, then an increase of $1 in the monetary base will cause money supply to increase by $8. Fiat money is to any exchange medium that the Government declares to be the legal tender in the nation state. It does not have any intrinsic value – its value depends on the confidence that the public has in the economic and political stability of the Government (Graziani, 1989). Its production does not involve any real economic cost. Therefore, its supply is never self-limiting. Credit money refers to monetary claim, which is future in nature, which is made against an individual, but not the state, and can be used in the purchase of goods and services. Assumptions of the Money Multiplier There are a number of assumptions that underlay the money multiplier. Some of these assumptions include; Commercial banks maintain a fixed percentage of the deposits made by customers in order to meet the reserve requirement. Commercial banks customers make payments among themselves only by cheque and not through withdrawal of cash from the bank. When customers are not paid, they do not result to withdrawing the money they have in the bank. Hypothetical Situation Lets consider a situation where the reserve requirement is 10%. A commercial bank customer makes an initial deposit of $1000. $100 of this will be reserved, and the bank can lend the remaining $900, that is, 90%. The borrower will draw a cheque against the balance of $900 in the account while the payee will deposit the same to the bank. At this point, the customers balances will have increased by the initial $1000 add the $900 from the deposit of the new cheque. This totals to $1900. The commercial bank will be able to lend 90% of the $900, making a further increase of $810 and the total deposits equal to $2,710. The process is repetitive, and the bank deposits increases to 10 times the amount that was originally deposited ($10,000 and not $1,000). From this hypothetical situation, it can be inferred that the money multiplier is equal to the ‘reciprocal of the reserve requirement’. This means that when the reserve requirement is 15%, then the money multiplier can be determined as 1/0.15 = 6.67. Complex Money Multiplier The above assumptions in the simplified money multiplier do not usually hold in a real life situation. This is because some of the customers will keep idle cash with them as opposed to keeping them in the bank. On the other hand, commercial banks will hold balances from the central bank for transaction purposes apart from the reserve requirement. A complex multiplier formula is defined as follows; (1+ c)/(r +e +c) Where; c is the percentage of money that is held by customers in the form of cash r is the reserve required by the central bank e is the reserve that is kept by the bank, in addition to the reserve, which is required by the central bank. Criticism of the Money Multiplier Morris (1969), states that the Government has the role of economic stability through the central bank. The central bank achieves this through its fiscal and monetary policies. Inflation is undesirable in any type of economy all over the world. Its level should be maintained at the minimum since it can never be zero. Employment and inflation are two unnecessary evils that the economy has to deal with them. A solution to either creates a problem with the other. Their levels have to be kept at manageable levels. The central bank combats inflation through regulating the supply of money in the economy (Keen, 2009). The central bank increases money supply through printing of money. This kind of money is referred to as fiat money. When the central bank creates fiat money, it lends them to the commercial banks. The commercial bank will now have some deposits which it can in return lend to the individual members of the public and other private financial institutions. Note that the central bank lends the commercial bank as a lender of last result at some discount rate. The commercial banks in turn lend to private entities at a rate slightly higher than the discount rate. This makes them continue being in the business of credit creation. Private individuals need this money for investment purposes (Kydland and Edward, 1990). When the central bank lowers the reserve requirement, it increases the funds available to commercial banks for lending purposes. Furthermore, if the central bank lowers the discount rate at which it lends to the commercial banks, then the commercial banks are able to transmit the same effect to the individual investors. They lend them at a lower interest rate. According to Minsky (1982) low interest rate encourages many individuals to go for loan from the commercial banks. Since they require this money mostly for transactions and consumption purposes, they will make withdrawals from the bank. Motives of Holding Money Moore (1979) observes that there are two major reasons why individuals will hold money; namely for transaction and speculative purposes. When the public hold money for transaction purposes, they use them mainly for buying consumable goods and services. Notice that these individuals have borrowed money from commercial banks, but instead of making payments through cheques, they withdraw this money and hold them in the form of cash. These individuals will go out there with their cash for transaction purposes. The result is that there will be an increase in money supply in the economy. This causes inflation since there is too much money facing too few goods (Wray, 2009). This is known as demand caused inflation. Therefore, the creation of fiat money by the central bank brings about inflation. It does not result to multiplier effect as it is commonly expected. Individuals also hold money for speculative purposes. This means that they hold idle cash in the hope that a viable investment opportunity will arise so that they can take advantage of it. This means that the commercial banks will have less money with them to be used in the credit creation. This limits their ability to create credit. Speculative demand for money has been shown to depend on interest rate. These individuals will be motivated to deposit their money in the commercial banks if the interest rate is high. Increase in money supply causes the interest rate to lower. That is, money supply and interest rate has an inverse relationship. The higher the money supply, the lower the interest rate. The interest rate will lower with an additional increase in money supply until it can lower no more. That is, a further increase in money supply does not cause a decrease in interest rate. This is called the liquidity trap of interest. This is illustrated by the diagram below: Notice from the graph that at the liquidity trap of interest, there is no further decline in interest rate even if there is an increase in money supply (M4). When this level is attained, the central bank cannot succeed in credit creation. This is because the individual will prefer to consume their money rather than hold them for speculative reasons. Therefore, the transaction demand for money will be higher than the speculative demand for money. This shows that the creation of fiat money increases the supply of money into the economy. Increase in money supply causes the interest rate to go down (Weygandt, et al., 2009). Low interest rate motivates private individuals to borrow from the commercial banks. These individuals will deposit some of these borrowings in their own bank accounts. However, they will retain some of the money in hard currency to use for transaction purposes. This decreases the bank deposits that can be used in the credit creation processes. Hence this model does not result to a multiplier effect. Suggested Model This paper suggests a money creation model in which there is no discount rate by the central bank to the commercial banks. Commercial banks should play the role of agent in an agency relationship with the central bank. That is, the central bank and the commercial banks are one and the same. The central bank creates fiat at an insignificant cost. Therefore, it should not earn a return for which a cost has not been incurred. Since commercial banks are in an agency position, the central bank will from time to time dictate the terms of trade that should be followed by all commercial banks. This prevents commercial banks from engaging in anti-competitive behaviours. Operating on a common ground will prevent inter-banking by the commercial bank customers. Theory behind the model Commercial banks form the available means of payments to the public or the market. Commercial banks contribute to money supply through the bank deposits. Generally, these deposits are in two major categories, namely the credit deposits and the cash deposits. Cash deposits (also referred to as primary deposits) mean the kind of bank deposits that are created when commercial bank customers deposits hard currency with the bank. The customers do not get any net addition through this kind of payments. Strictly speaking, the customer has only succeeded in changing the form of his asset. That is, change of cash in hand to cash at bank. However, the customer has affected his liquidity position since cash in hand is more liquid than cash at bank. This is because it is the same cash which the customer had in his hands that have been replaced by a commercial bank deposit. Notice that the customer will not exercise full control of his funds at the bank. The bank makes a reserve of these deposits. At no one time will the customer withdraw all his deposits with the bank. He is limited to, lets say, 90% of this deposit. Commercial bank as a financial firm has a profit-making objective. It derives its operating surplus from the discrepancy between interest paid (on its liabilities) and interest earned (from its assets). The commercial bank maintains a balance sheet in which the balances of cash appear on the asset side (Warren, 2009). However, it cannot derive any income (interest) from these cash balances. Commercial bank earns interest income from the loan products and other advances to its borrowers or customers. When a customer borrows money from the bank, it becomes an additional form of payment with them as it causes the creation of bank deposits, which is to the advantage of the borrower. That is, when a bank extends loan, it creates deposit-liabilities which increases the money supply (means of payment). The created loan deposits are called derived deposits or secondary deposits. Numerically, the increase in the supply of money should be equal to the amount of deposit liabilities that are above the cash holdings (Moore, 1979). This is what is referred to as credit creation. Since the bank is a profit-making institution, it will lend for long period and borrow for a short duration (Obert, 2005). Its contracted liabilities will be short term in nature while its acquired assets will be long term in nature. This ensures that the commercial bank holds the customers’ deposits long enough to utilize them in credit creation. However, it will maintain its liabilities for a short time since it is a cost to the bank. The assets of the commercial banks are mainly advances and loans. These earn the commercial bank a huge interest income. On the other hand, most of the liabilities of the bank are deposit liabilities. Some of these do not earn interest while the interest earned by others is relatively low. Therefore, commercial banks will strive to maximize the deposit liabilities and mostly the demand deposit category. Limitations of the Model The money multiplier under this model will not be achieved if the following circumstances materialize: The reserves of the commercial bank were purely made in cash Commercial bank customers did not hold hard currency and use cheques in their transactions. The assets and liabilities of the bank are equal An ideal situation occurred where nobody borrowed from commercial banks Measures to Counteract the Limitations Central bank plays a critical role in influencing the interest rate that commercial banks charge on the loans they extend. This interest rate should be low in order to encourage private individuals to borrow from commercial banks. Notice that when there is no borrowing from commercial bank, the credit creation process is heavily affected. This in turn impacts negatively on the money multiplier. According to Handerson (1987) the central bank regulates the general interest rate through its various measures like the reserve requirement, engaging in the open market operations, the discount rate and the cash ratio basis. In order to lower the interest rate, the central bank will lower the required reserve. This increases the bank deposits available to the commercial banks for purposes of lending. This means that the size of loanable deposits will be high (supply is high). The forces of demand and supply will work to bring the interest rate down. Interest rate is the price (cost) for the loan. This will be in line with the low of supply which states that when there is a high supply, the price is relatively low (Donald, et al., 2009). The reverse is true. Many private individuals will be motivated to borrow from the bank since it is affordable. These individuals will in turn deposit this money in their bank accounts. This will increase the bank liabilities. The result of this is excess deposit liabilities over the assets of the bank. This means that commercial bank will have extra resources at their disposal that they can lend to others. This process will continue until the final bank deposits are higher than the initially deposited money. Facts about the Suggested Model The money multiplier model asserts that the multiplier is equal to the reciprocal of the central bank’s reserve requirement. However, the multiplier obtained under this model is less than the reciprocal of the central bank’s reserve requirement. This is due to the fact that not all money in the hands of the public is in proximate access to the bank. By extension, it means that the fiat money created does not take part in credit creation in aggregate. In addition, the supply of money is not constant since it is presumed that the central bank takes time before creating some more fiat money. Some fiat money is subtracted from the stock of money supply through loss and wear and tear. However, this model does not account for the probability of money laundering, which injects more fiat money into the economy, and thereby “increasing” the supply of money. This model estimates the money multiplier to be equal to half of reciprocal of the reserve requirement. That is, if the reserve required is 10%, then the money multiplier is (1/0.1)*1/2 = 5 Justification of the Model The central bank reserves some of its deposits for transaction and other purposes. Moreover, some customers will retain some cash with them rather than depositing everything with the bank. The total of these is estimated to be just equal to the reserve requirement. Note that these amounts, in addition, to the reserve required do not take part in credit creation. References Donald, E. et al., 2009. Intermediate Accounting. New Jersey: John Wiley and Sons. Fullwiler, S. T., 2007. Macroeconomic Stabilization through an Employer of Last Resort. Journal of Economic Issues, 41(1), pp.93-134. Graziani, A., 1989. The Theory of the Monetary Circuit. Themes Papers in Political Economy, Spring, pp.1-26. Handerson, J., 1987. Macroeconomic Theory. New Jersey: McGraw-Hill Publisher. Morris, F. E. 1969. Controlling Monetary Aggregates. Nantucket Island: The Federal Reserve Bank of Boston, pp.65-77. Keen, S., 2009. Bailing out the Titanic with a Thimble. Economic Analysis & Policy, 39(1), pp.3-24. Kydland, F. E. and Edward, C. P., 1990. Business Cycles: Real Facts and a Monetary Myth. Federal Reserve Bank of Minneapolis Quarterly Review, 14(2), pp.3-18. Minsky, H. P., 1982. Can 'It' Happen Again? A Reprise. Challenge, 25(3), pp.5-13. Moore, B. J., 1979. The Endogenous Money Stock. Journal of Post Keynesian Economics, 2(1), pp.49-70. Wray, L. R., 2009. An Alternative View of Finance, Saving, Deficits, and Liquidity. International Journal of Political Economy, 38(4), pp.25-43. Obert, O., 2005. Organizational Behavior and Industrial Psychology. New York: Oxford University Press. Warren, R., 2009. Governmental Accounting Made Easy. New Jersey: John Wiley and Sons. Weygandt, J. et al., 2009. Managerial Accounting: Tools for Business Decision Making. New York: John Wiley and Sons. Read More