Economic Knowledge (3) — Money Supply and Reserve Requirements — (Contrary to the Textbooks ... )

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Today's puzzle deals with this proposition:

2. Introducing a system of 100 per cent reserve requirements on the commercial banks would give the central bank control of the money supply.

True or False?

My answer: False.

Brief explanantion of my answer: 

Contrary to the textbooks, in exerting influence on high powered money (currency + bank reserves) the central bank is not able to control the money supply. 

Less significantly, because the amount of currency in circuation (like bank reserves, a liability of the central bank) is not under the control of the central bank, depending instead on demand as displayed by the public.

More significantly, the central bank may increase the bank reserves in the banking system (by purchasing securities), but it cannot force the banks to expand lending in lockstep with the new level of bank reserves. Banks tend to choose the level of lending according to market conditions and will not issue new credit if economic conditions are too slack to provide them with a sufficient supply of creditworthy borrowers.

Even more significantly, contrary to the textbooks, banks increase lending activity as they see fit, even when exceeding the limit set by reserve requirements. A reserve requirement of 10% would, in theory, force/induce/but also absolutely limit a bank with deposits and bank reserves of $ 100 to generate new credit ( = new money) to the tune of not more than $ 90 ( = $ 100 x 0.10).

In reality, the central bank will accommodate any volume of additional credit issued by the banks. Having issued new credit in excess of reserve requirements, the latter will seek additional bank reserves in the interbanking market, after the event. And the central bank will ensure that any additional reserves are being supplied.

So the central bank is neither in a position to nudge banks into expanding the money supply by

•  forcing more bank reserves on them, 

nor is it able to limit the money that banks create through issuing loans by 

• strictly enforcing reserve requirements.

Control of the money supply via steering credit creation by private banks, therefore, is not a viable option for the central bank. Its main tool allowing it to exert substantial influence on economic activity is interest rate policy, whereby it sets the short-term interest rate which represents part of the funding costs of banks and serves as a signal that tends to ripple thorough the entire yield curve. Though, even this mechanism is of limited efficacy.

Monetary policy is a rather constrained tool. For more efficacious macroeconomic managment, government needs to revert to fiscal policy as well.

More on this in future posts.

Continued here.