Tuesday, April 14, 2009

The money mutiplier has stabilized

One of the most dramatic indicators of the financial crisis has been the collapse of the "money multiplier". The money multiplier is measured as the ratio of the money supply to the monetary base. The money supply is the sum of currency in circulation and bank deposits. The monetary base is the sum of currency in circulation and the reserves held by commercial banks (at the central bank). The money multiplier tends to be above 1 (and that's why it is called a "multiplier") and it is a measure of how much the money supply increases when the central bank raises the monetary base (think about the central bank printing money or increasing the amount of reserves available for commercial banks and what we are after is the final impact it will have on liquidity).

The money multiplier can collapse for two reasons. First, it can be that individuals mistrust banks and they decide to take their deposits away from their bank and keep their liquidity as cash ("under the mattress"). Second, it can be that commercial banks are worried about the future and they accumulate an unusually large amount of liquidity in the form of reserves without lending them to individuals or businesses. This is what we have observed since the summer of 2008, a very large increase in the amount of commercial bank reserves at the central bank and very little lending. The chart below (for the US economy) shows the collapse of the money multiplier at that time. We also see that in recent months the money multiplier has stopped declining although it remains at a very low level (below 1).

While the money multiplier was falling, the Federal Reserve increased dramatically the monetary base. This increase translated into a much smaller increase in the money supply because of the falling multiplier. As the multiplier stabilize and very likely starts growing towards its natural level (when banks stop holding large amount of reserves), the money supply will start growing. It will then be the signal to the central bank that it is time to reduce the monetary base in order to keep inflation under control. 

Antonio Fatás
on April 14, 2009 |   Edit