Core Economic Definitions & Theoretical Mechanisms
The traditional view of money creation focuses on the money multiplier, where central banks supply base money and commercial banks multiply it through fractional reserve lending. However, the modern endogenous theory posits that banks create deposits exactly when they issue loans, making money creation demand-driven rather than reserve-constrained.
Underlying Mathematical Formulas & Equations
Money Multiplier (m) = 1 / Reserve Requirement Ratio (rr). Broad Money (M2) = Base Money (M0) * m.
Concrete Worked Numerical Example
Assume a central bank injects $1,000 in reserves and the reserve requirement is 10%. A bank receives the $1,000, holds $100 in reserves, and lends $900. The $900 is deposited in another bank, which holds $90 and lends $810. This process theoretically expands total deposits to $10,000 ($1,000 * 1/0.10).
Real-World Empirical Application: Historical Case Study
The post-2008 Quantitative Easing (QE) by the Federal Reserve vastly expanded base money, but broad money did not scale proportionally because banks held excess reserves instead of lending, challenging the strict multiplier model.
Limitations, Criticisms, and Competing Schools of Thought
Monetarists rely on the multiplier, but Post-Keynesians argue credit is endogenous; banks lend first and seek reserves later. Thus, the money multiplier often fails to predict actual money supply dynamics.
Comprehensive FAQ Section
Does the central bank control the money supply?
Only partially. While it controls base money, broad money is driven by commercial bank lending decisions.
Academic References & Primary Source Citations
- Bank of England, ‘Money creation in the modern economy’ (2014).
- Kiyotaki, N., & Moore, J. (1997). Credit Cycles. Journal of Political Economy.