The money multiplier is dead

The money multiplier is dead

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The Bank of England’s Quarterly Review contains a detailed description of how money creation works in the UK’s fiat money economy.  Partnered with a useful primer on money and a couple of explanatory videos entertainingly hosted in the gold vaults (where is the pallet labelled “Deutschland”, I want to know?), it is a comprehensive and clearly-written guide.

And it is controversial. It rejects conventional theories of bank lending and money creation (my emphasis):

“The reality of how money is created today differs from the description found in some economics textbooks:

• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.

• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.”

To be sure, numerous papers from many eminent researchers and august institutions (including the Fed, the IMF, the ECB and the Bank for International Settlements) have cast doubt upon conventional theory as an adequate explanation of money creation in a modern fiat money system. But to my knowledge this is the first time that a central bank has presented an explanation of money creation that so comprehensively departs from conventional orthodoxy.

Predictably, heterodox economists such as Steve Keen and Cullen Roche, who have written extensively about endogenous money creation and the inadequacy of conventional theory, are rejoicing. Equally predictably, perhaps, others argue that the Bank of England’s paper is confused, contradictory or simply wrong. It is of course difficult for mainstream economists to accept that the theory they have believed and taught for so many years – and upon which many models of the economy depend – is simply inadequate. But there are some genuine concerns that need addressing.

It is hard to argue that the Bank’s simple explanation of how lending works is wrong:

“Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.”

Anyone who has ever bought a house of course knows that their bank account is credited with the amount of the loan, and they then pay that money to the seller. But many people think the money is somehow “transferred” from other people’s deposit accounts.  As the Bank shows in this neat chart, this is not what actually happens:

Main article image

Note that the balance sheets of both banks and consumers increase as a result of lending activity. In other words, banks do not “lend out” deposits. No-one’s deposit account is reduced in value because someone else has borrowed the money. New deposits are created when banks lend.

The reason for the controversy around this appears to arise from the practice of banks pre-funding large lending commitments. As the ECB explains (p.38),

“business unit gives all of its deposits to the ALM desk to be invested at market rates…..'and goes to the ALM desk for all of its funding requirements if it wishes to grant loans”

This appears to suggest that asset & liability management (ALM) functions in banks act as internal clearing houses, taking pooled deposits from deposit-taking business units and allocating them to lending units. On this basis, some argue that banks do in fact “lend out” deposits.

To a degree, ALM units do indeed do exactly that. But the funding they provide is not for lending as such, it is for deposit drawdown. Loans still create deposits, but when the loan is drawn, it is the new DEPOSIT that is paid out. If that payment goes to a different bank, that leaves an asset-liability imbalance on the bank’s books, which must be funded. It is the job of ALM units to ensure that such mismatches are covered: if there is insufficient existing liquidity to fund the mismatch, it is their job to obtain funding from markets or (as a last resort) from the central bank to close the gap. Pre-positioning funding is a prudent operational practice designed to prevent sudden liquidity shortfalls.

The Bank of England also notes that when loans are paid off, bank credit money (so-called “broad money”) is destroyed. Under normal circumstances, repayment of one loan would be replaced by creation of another, either to the same borrower (refinancing) or to another borrower, so the net effect on the money supply is zero. But when more loans are being paid off than are being created, money in circulation diminishes. Not surprisingly, the Bank commends QE as a replacement for inadequate bank credit creation in a deleveraging cycle. Personally, I remain unconvinced of its effectiveness, because of its unfortunate distributional effects: I can’t help thinking that direct reflation would be more effective.

The other controversial part of the Bank of England’s analysis concerns the role of the central bank in managing the money supply. Basically, they argue, the central bank cannot and does not fix the quantity of money in circulation. Most people would accept that the central bank cannot directly control the amount of money created by commercial banks when they lend (so-called “broad money”. But the Bank of England also argues that the central bank cannot fix the quantity of base money either. This is in direct contradiction of most economic textbooks, which explain monetary policy thus:

“central banks determine the quantity of broad money via a ‘money multiplier’ by actively varying the quantity of reserves….central banks implement monetary policy by choosing the quantity of reserves. And,because there is assumed to be a stable ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank deposits as banks increase lending and deposits.”

But the Bank is uncompromising:

Neither step in that story represents an accurate description of the relationship between money and monetary policy in the modern economy. Central banks do not typically choose a quantity of reserves to bring about the desired short-term interest rate. Rather, they focus on prices — setting interest rates. The Bank of England controls interest rates by supplying and remunerating reserves at its chosen policy rate. The supply of both reserves and currency (which together make up base money) is determined by banks’ demand for reserves both for the settlement of payments and to meet demand for currency from their customers — demand that the central bank typically accommodates.”

So reserve creation responds to demand for bank loans, rather than driving it:

“This demand for base money is therefore more likely to be a consequence rather than a cause of banks making loans and creating broad money. This is because banks’ decisions to extend credit are based on the availability of profitable lending opportunities at any given point in time.”

I have been saying this ad nauseam for as long as I can remember. Banks lend when the risk/return profile is in their favour. When it is not, no amount of extra reserve creation will make them lend.  Monetary policy therefore focuses on the PRICE of money, not its quantity, since changes in the price of money will influence the returns available to banks for lending and therefore their willingness to lend. 

Though as the Bank explains, other factors are important too- such as macroprudential policy, consumer demand for loans and general economic circumstances. I therefore question their assertion that the quantity of money “ultimately” depends on the monetary policy stance. Did the price of money ultimately cause the credit bubble that burst spectacularly in 2007/8? If so, it is a massive indictment of central banks. Personally I think a rather less grandiose view of monetary policy is appropriate: monetary policy influences lending, but in the end the decisions are made by commercial banks and their customers, who are as prone to irrational behaviour as anyone else. Malfunctioning credit markets are the result of bad decisions by all players, not just central banks.

There is much, much more in this document. I strongly recommend reading the whole piece. But if there is one lesson that should be drawn from this, it is that fiat money systems simply do not operate in the way that classical economic textbooks describe. The money multiplier explanation of money creation can at last be consigned to the dust of history. 


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I'm not an expert of finance, but I've tried to understand and analyse the paper (and a lot of other questions in context). (

One thing I do marvel about is why they don't mention the need for collateral. For all I know, central banks don't just dish out money to commercial banks just so. And they do not (or at least not normally) accept private credit contracts as collateral. So banks would be restricted in their central bank borrowing by the amount of APPLICABLE collateral. Which would be far less than then amount of credits, or credit-created deposits, of banks.
Or is my assumption wrong?

Good piece on an interesting paper. A quick question:

"The Bank of England also notes that when loans are paid off, bank credit money (so-called “broad money”) is destroyed. Under normal circumstances, repayment of one loan would be replaced by creation of another, either to the same borrower (refinancing) or to another borrower, so the net effect on the money supply is zero."

What about the interest that each loan entails? It surely isn't to be destroyed after loan repayment so total money is increasing after all?


I guess the money multiplier might sometimes be taught as if it can be assumed to be a constant so that central banks can control M by varying H. And I guess it might sometimes be taught that bank lending is always reserve constrained. If so I'd agree these would be important errors. But on the the very first things we get students to do is graph the money multiplier over time - it's obviously not a constant! And the idea that central banks cannot control the quantity of money if they are interest rate targeting - in the short run at least [*] - is hardly news to mainstream economics. I am not sure how many main stream economists who actually study banking (as opposed to having once taken some undergrad classes they vaguely recall) think lending is reserve constrained. But actually didn't somebody catch Krugman writing something like that?

* Nick Rowe has defended the idea that in the long-run the central bank does control the money supply if you allow for it to change its interest rate target if it wants to, for that purpose

Frances Coppola


I do think getting the precedence of loans over deposits right is important, actually. And the fact that reserve scarcity is only a marginal constraint on lending. But I share your views on Graeber's article. There is some post-Keynesianism in the Bank of England's piece, but they certainly aren't wholeheartedly adopting MMT.

I am thinking about another post taking apart the more extreme MMT ideas about the creation of money and the relationship between central bank & government. They seem to think that government spending can safely be allowed to dominate money creation. Sargeant & Wallace, writing just after the high inflation of the 1970s, thought otherwise.


but what puzzles me is that this BoE paper is being widely interpreted as some admission that orthodox account of banking is *wrong*, whereas I see it as a minor qualification of orthodox account of banking that one finds in first year undergrad text books. Certainly anybody with an economic degree should know fractional reserve banking creates money.

I thought about commenting on that awful David Graeber article on CIF, but life's too short.

Frances Coppola


You'd be amazed at the number of people I've spoken to who refuse to admit that banks create money when they lend. I've had this conversation so many times. Indeed I suspect that is why the Bank of England has emphasised this in its paper, too. Banks are money creators, not credit intermediaries. You and I know that, but I reckon about half the UK population doesn't.


yes I always get the impression that actual points of disagreement us are very slim. But who doesn't think banks create money? Certainly not orthodox economics, which uses that simple money multiplier story to explain how they do it. In that story banks are "pure intermediaries" *and* their lending creates money

Frances Coppola


I agree the "money multiplier" theory does convey the principle that banks create money when they lend. But I was replying to those who DON'T think banks create money - those who think they are pure intermediaries.

Thanks Frances.

well I still think as a "theory of money creation" it's still useful to get some important and true ideas across, so long as it's not mistaken for a complete account of what happens. It does after all communicate the idea that fractional reserve bank lending creates money. And I think banks *do* lend out deposits, in the sense that their assets are loans and their are liabilities (often, largely) deposits, it's just that they don't need the deposits first before they can loan second.

I remain mystified by the way ... I cannot see where the claim "banks lend out deposits" entails deposits "reduce in value" - as I have already written, if you believe the banks lend out deposits story, the whole point is that deposits do *not* lose value, that's how money is created, the depositor still has the money they deposited *and* it's used to finance loans and create more money.

Frances Coppola

Luis, you may have been teaching your undergrads correctly, but so many people misunderstand this that it seems far too many undergrads are NOT taught correctly. Indeed that is probably why the Bank of England has gone to the trouble of writing an entire paper about this.

I agree that the money multiplier as an identity is alive and well. It's as a theory of money creation it is dead.

The comment about deposit accounts not reducing in value is not about the money multiplier. It's about the prevalent belief that banks lend out deposits. They don't.

the standard econ text book account involves the idea lending creates deposits in another bank because it's a simple parable taught to undergrads who have yet to encounter the idea that the amount of money in an economy does not equal the number of pound notes. It really isn't hard to teach the standard account, topped and tailed with a few sentences about the gap between a simple story and reality. For example it's easy to say that when a loan is withdrawn and spent, sometimes it is spent and deposited by somebody with an account at the same bank. It's easy to tell students that in reality banks don't have to wait until the receive a deposit before they can lend, but that in reality they can lend first, finance the loan second.

on thing the standard undergrad econ account omits is the stage when I go into a bank, agree to borrow £100 and find myself with a new deposit account at this bank with £100 in it. That's another sense of "loans create deposits" that economists rightly ignore because, as I think we have discussed before, it makes sense to skip straight to what happens when I spend my £100, i.e. the loan is actually drawn down.

But I disagree it's money multiplier RIP - taught correctly, the money multiplier is an accounting identity, you can derive it from manipulating other accounting identities, it is not wrong, it's true by definition. For avoidance of doubt - we have also covered this before - of course I agree banks lend when they see a profit, and that bank lending is not constrained by availability of funds. So if the money multiplier story is told with that conclusion, it's out and out wrong, I agree. We used the money multiplier "story" to teach our undergrads how the central bank cannot control the quantity of money in circulation,.

btw I am mystified by this: " No-one’s deposit account is reduced in value because someone else has borrowed the money" whoever thought that? The standard econ multiplier account says I deposit £100, bank retains say £10 in its vaults and lends out £90, but I still have £100 on deposit, no suggestion that anybody's deposit account has reduced in value - in fact it's absolutely crucial to the story that deposits accounts do not reduce in value otherwise money would not be multiplied

Celebrate the death of "Jimmy Stewart" banking and let the Left know.

What you seem to overlook it’s the role of governments in determining the base money and as a consequence the money supply. It is true that banks lend when" the risk/return profile is in their favor", but this does not apply in the case government who is the biggest consumer of the economy. The price of money is fixed on the basis of its destructive needs and those of its followers. The rate of interest does not reflect the propensity to invest, but the government’s propensity to consume and measures the dissipation inflicted to the entire economy. A concept which monetarist a la Cullen escape from. The government never invests because it does not extend the economy productive base, its consumption shrinks it. So money is created by central bank to accommodate the price of credit in favor of the government to perform the shamble. Otherwise how to explain our permanent crisis?, With the animal spirits?. The price of credit reflects this reality and that’s why, as you write, “monetary policy focus on the price of money” not its quantity”. In fact if you are a monopolist you can fix either the price or the quantity but you cannot fix both. But in the case of money, the most required “good” in the economy, its price determines its quantity because people do not have choice: for borrowing they cannot surrogate money with something else.

Frances Coppola


The reason why this is news is that it means endogenous money theory has been officially endorsed by a major central bank. Positive Money's book and the papers from the Fed, IMF and BIS that I cited in the post all represent the views of independent researchers, not an official stance by a major institution responsible for monetary policy. Very different.

Great recap.

"Though as the Bank explains, other factors are important too- such as macroprudential policy, consumer demand for loans and general economic circumstances. "

Moreover none of these factors/variables are wholly independent. Each are dependent variables which end up influencing the other factors as they share reflexive relationships which are consistent with feedback loops.

Francis-why is this news? I read the same story in the excellent book below, which had supporting quotes from various BoE people.

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