Economic Knowledge (8) — Central Bank and Money Supply, Monetary Base, and Money Multiplier

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Proposition, true or false:

To ensure that the financial system is stable, the central bank has to allow the money supply to be driven by the monetary base.

My answer:

false.

My explanation:

The question requires some untangling. You need to figure out the theory according to which the financial system is stable, when the money supply is driven by the monetary base. 

Roughly, this theory has it that the central bank is in command of the monetary base, through which it controls the money supply. The transmission mechanism that translates central bank controlled monetary base into (central bank controlled) changes in the money supply is the money multiplier.

The monetary base is currency plus reserves. While currency is not under the control of the central bank, depending on popular demand, the greater part of the monetray base is under control of the central bank - bank reserves. In other words: the central bank can increase or decrease the monetrary base by increasing or decreasing bank reserves (by buying or selling government bonds and by other means - more on that in other posts).

Standard theory assumes that there is a fairly constant money multiplier which turns an increase in bank reserves into an increase in the volume of loans and thus into a larger money supply.

Empirically, there is no such constant relationship; banks do not automatically turn larger reserves into larger loan committments.

So, I suppose, one version of a correct answer to the above question is: there is no way for the central bank "to ensure that the financial system is stable" by allowing "the money supply to be driven by the monetary base." The tarnsmission mechanism that would extend the central bank's control over the monetary base into control over the money supply does not exist/work, contrary to what standard theory assumes. Notably, an increase in the  monetary base does not necessarily bring about a proportional increase (or any increase at all) in the money supply. 

[Die weit verbreitete Theorie (und Schablone für praktische Zentralbankpolitik), wonach die Zentralbank in der Lage sei, durch Steuerung der Geldbasis (Bargeld plus Bankreserven bei der Zentralbank) die Geldmenge in ihrem Sinne zu beeinflussen, ist irrig. Zwar ist die Zentralbank in der Lage, die Geldbasis weit gehend zu steuern, doch ist der Transmissionsriemen in Wirklichkeit nicht vorhanden, der Änderungen in der Geldbasis in proportionale Änderungen der Geldmenge übersetzen könnte. 

Die Geldbasis besteht hauptsächlich aus Bankreserven, deren Menge von der Zentralbank kontrolliert werden kann (durch Kauf und Verkauf von Staatsanleihen und durch andere Maßnahmen), aber es ist nicht so, dass Banken bei einer Ausweitung ihrer Reserven automatisch das Kreditvolumen erhöhen. Der Geld-Multiplikator, der eine konstante Beziehung zwischen zentralbankinduzierter Erhöhung der Geldbasis und kreditinduzierte Geldmengenausweitung unterstellt, ist ein akademisches Konstrukt, das einer Entsprechung in der Praxis entbehrt.]