Monetary Aggregates Compared

The Fed has Provided the Bulk of Money Supply Growth since 2008

We have discussed the topic of money supply growth extensively in these pages over time. Below is a brief recap of how the system works in the US. Note that although fractional reserve banking and central bank-directed and backstopped banking cartels are in place all over the world, there are several “technical” differences between them. So the workings of the US system cannot be transposed 1:1 to e.g. Japan’s system or the euro system.

There are two possibilities of growing the fiat money supply: In “normal” times, commercial banks will extend loans which are partially “backed” by fractional reserves. These loans create new deposit money, which once again can serve as the basis of further credit creation, which again creates new deposit money, and so forth. It can be shown mathematically that based on a hypothetical fractional reserve requirement of 10%, extant deposit money in the system can be grown 10-fold (for a detailed discussion of the “money multiplier”, see here).

Golden Growth

In actual practice, reserves have not represented a constraint for credit and money supply growth by commercial banks for quite some time. In the US banks can e.g. “sweep” money from demand deposits into so-called MMDAs (money market deposit accounts) overnight, letting these funds “masquerade” as savings deposits, which allows them to circumvent reserve requirements. Moreover, if credit demand is so strong that interbank lending rates (i.e., the Federal Funds rate) threaten to rise above the target rate set by the Federal Reserve, the central bank will supply additional reserves to the extent necessary to keep the rate on target. Thus the required fractional reserves will be supplied even if commercial banks don’t have sufficient excess reserves to lend to banks short of reserves.

None of this has been of importance since the 2008 crisis however, as “QE” has created such an overhang of excess reserves that interbank lending rates have continually wallowed close to the lower end of the 0.00%-0.25% Federal Funds target corridor. Moreover, up until late 2013/early 2014, commercial bank credit growth had slowed to a crawl anyway. So barely any money supply growth has come from the banking sector after the crisis. Enter the Fed, and “QE”.

In theory, if the central bank buys securities directly from banks, it would only issue bank reserves in payment (the selling bank receives a check drawn on the Fed, and upon depositing it, its reserves account at the Fed is credited). In actual practice however, QE in the US system concurrently also creates new deposit money at close to a 1:1 ratio. Most of the broker-dealers the Fed uses as counterparties in its open market operations belong to banks, but they are legally distinct entities (i.e., they are legally non-banks). Hence, when their accounts are credited, not only bank reserves are created, but new deposit money as well.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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