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Reserve Requirements

Why Central Banks Don't Control the Money Supply: A Visual Tour of the Macroeconomic Dynamics of Bank Loans, Reserve Requirements, Capital Requirements, and Cash Withdrawals (INCOMPLETE)

Pre-Requisite Tutorial:

How Loans Create Money

The "How Loans Create Money" tutorial focused on a single bank and borrower. (Please review that tutorial before this one.)
This tutorial covers the economy-wide dynamics of bank lending. You'll see from the perspective of Post-Keynesian economics why the mainstream theories of fractional reserve banking and the money multiplier are wrong! Among other implications, this means broad money supply is NOT determined by the combination of base money supply plus central bank policy settings!
After each page you can review the material or click Next (at the top of the page) to continue.

Let's review the main balance sheets that will play a role in this tutorial.

First, the "All Banks" balance sheet represents the banking sector (all banks combined).
Second, the "All Households" balance sheet represents all households aggregated together. (Companies borrow too but are left out for simplicity since the borrowing dynamics would be the same.)
Third, here is the central bank's balance sheet. The US central bank is the Federal Reserve. As part of the federal government, the central bank is responsible for the currency (dollars), setting interest rates, and overseeing the commercial banking system.
The orange bars track the size of the base money supply and broad money supply. Try mousing over "broad money" to see its components highlighted in the balance sheets below. In this example, the broad money supply is exclusively bank deposits owned by households.
"How Loans Create Money" (the prior tutorial) explained that the only limiting constraint in the quantity of bank lending is banks' ability to find and assess credit-worthy borrowers. This tutorial will demonstrate why this is true even at an economy-wide level with a central bank involved.

Let's start with reserve requirements and why the mainstream concept of a "fractional reserve" banking system is mistaken. So, what are reserve requirements and how do they relate to bank lending and the money supply?

Reserve requirements are dictated by the central bank. They specify the quantity of reserves that each bank must hold relative to its customer deposits. For example, a 30% requirement requires $30 of reserves (assets) for every $100 of deposits (liabilities). This arrow shows the relationship overlaid on our banking sector balance sheet.
Do banks check their available reserves before granting new loans? No! This is a key fact the "fractional reserve" view of lending gets wrong! Remember, banks don't actually lend out reserves because loans create deposits (aka money)! The reality (as any senior banker could tell you) is that banks lend first and acquire required reserves at the end of the day.
How? At the end of the day, if an individual bank is short of reserves, then to meet reserve requirements, option #1 is to borrow from other banks with excess reserves. The "How Loans Create Money" tutorial stated that banks don't lend reserves -- but the exception is they can lend them to other banks!
Let's watch a demo. Here is Joe's bank. After granting the car loan, its reserve ratio is 20% ($20 of reserves divided by $100 of deposits) -- but since the reserve requirement is 30%, it is short reserves. In this scenario, other banks (below) have excess reserves, so Joe's Bank will borrow reserves from them in the overnight market.
Watch Joe's bank's balance sheet expand as other banks lend to it. The result, after borrowing an extra $10 of reserves, is the bank can meet its 30% reserve requirement.

What are Reserves?

Reserves =
  Reserve Balances
    +
  Currency in Bank Vaults

Central banks are never reserve-constrained.

Reserve balances are managed electronically, like points on a scoreboard. Thus they are quick to create and "destroy" as needed during central bank policy operations.

Physical currency (vault cash) is just a subset of reserves that satisfies consumer demand to make withdrawals and conduct some economic transactions using notes and coins. The reserve mix (between reserve balances and currency reserves) can be adjusted by the central bank as needed.

The Macroeconomic Balance Sheet Visualizer shows both together.

The central bank has unlimited capacity (assuming no gold standard or other currency convertibility) to create reserves and inject them into the banking system as needed for reserve requirements and liquidity needs to be met. Doing so is an automatic daily process. The mainstream belief about the money multiplier is backwards!

On the last page the bank borrowed reserves from other banks. What if no banks have any reserves to spare? Answer: the central bank is the bank that ALWAYS has reserves to spare, since reserve balances are essentially numbers in a computer! The remainder of this page illustrates ONE form of this dynamic, but there are others (e.g., in the US the central bank has moved to a "floor" system involving excess reserves).
If the entire banking system is short of reserves, then the system-wide unmet demand for reserves would start to push the overnight interest rate above the central bank's policy target! (Watch the black "Demand for Reserves" curve shift right)
But the central bank defends its target rate at all times as part of monetary policy, so its daily open market operations automatically inject additional reserves into the system as needed (using a variety of methods). Thus at the end of the day, the central bank adds or removes reserves from the banking system such that banks can meet their reserve requirements! (Watch the blue "Supply of Reserves" line shift right so the two lines intersect once again at the target rate.)
No loans are prevented or retracted due to insufficient reserves! Reserve requirements control neither the quantity of money nor the quantity of bank lending! In fact, the "money multiplier" causation is the reverse of conventional wisdom: the quantity of broad money (created via bank lending) determines the base money supply! (In a traditional "corridor" system).
So what is the purpose of reserve requirements? They ensure sufficient liquidity in the banking system, thus allowing smooth operation of the payments system (clearing of checks between banks, etc). But the central bank always defends the payment system even without formal reserve requirements -- there are some countries (such as Canada) without reserve requirements!

Hands On Interactive Exploration:

SIMPLE VERSION

ADVANCED VERSION

Show Preview of Controls (not functional!)

1. Choose Policy Settings:

Monetary Policy System:

Monetary Policy Tool:

Show Treasuries Bought/Sold From:

2. Simulate Private Sector Borrowing:



3. Observe Central Bank Reaction:



Invalid Action: One or more balance sheets has insufficient assets or liabilities. Try another action first or reset the balance sheets.

Now you get to control the balance sheets to see how these concepts operate. (Or click NEXT again to preview parts 2 and 3 and a list of supplemental reading.)

The slider in the sidebar on the right controls the quantity of bank lending.
Each day, the central bank MUST inject (or withdraw) sufficient reserves into the banking system to compensate for the change in loans outstanding.
The central bank has multiple reserve injection methods -- shown here are open market operations involving treasury purchases. Banks will not run out of treasuries, because the central bank also buys from households (etc), resulting in the same expansion in bank reserves.
Capital Requirements

Next let's look at capital requirements and why they don't limit economy-wide bank lending, either.

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Bank capital can be thought of roughly equivalent to net worth (balance sheet equity). The capital ratio is the ratio of net worth to loans, and can be thought of as a safety buffer to absorb asset writedowns (losses in net worth due to bad loans etc).

The below outline provides one explanation of why capital requirements do not limit system-wide loan expansion:

  1. A bank lends to a household (e.g., Joe).
  2. For regulatory reasons, the bank cannot make more loans without more capital.
  3. In this example (focused on testing limits) we'll make the assumption that retained earnings -- a normal source of capital -- are insufficient.
  4. Joe spends the loan proceeds on a car.
  5. The seller of the car (or someone else "downstream" in the circular flow of spending) now holds the additional banking system deposits that resulted from the original loan, and plans to save their newly earned income rather than spend it.
  6. The bank entices that person to convert bank deposits to bank capital by selling new bank shares at the current market price of capital -- note that both deposits and share capital are types of bank liability.
  7. The bank now has sufficient "room" in its capital ratio to extend new loans.
  8. This process can scale to any quantity of lending, since the deposits created by the lending ultimately are transformed into necessary capital and the system's loan expansion is thus "self-funding" with respect to capital requirements.
  9. This simple scenario includes a time lag for the deposits created by the loan to "get to" someone building a portfolio of savings, but in the economy there are numerous overlapping (but staggered in time) scenarios along these lines, plus many existing savings/investment portfolios, so lags should not be a limiting factor in system-wide loan expansion.
  10. This dynamic on its own is unlikely to put meaningful upward pressure on the price of bank capital (except in the context of a credit crisis and falling confidence). Bank shares are one of many investment portfolio choices and this example shows it's impossible for the economy to "run out of money" for buying newly issued shares.

Currency Withdrawal

Finally, let's look at why it doesn't matter (in terms of total bank lending capacity) whether borrowers withdraw their "money" as physical currency (notes and coins) instead of keeping deposits at the bank.

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Let's review all the details.

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External Resources with More Detail

Modern Central Bank Operations by Scott T. Fullwiler

Understanding central bank operations by Bill Mitchell

Building bank reserves is not inflationary by Bill Mitchell

Corridors and Floors in Monetary Policy by Federal Reserve Bank of New York

Unconventional monetary policies: an appraisal by Claudio Borio and Piti Disyatat of the Bank for International Settlements (BIS) Read Excerpt

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Theoretical Foundations of this Tutorial

Most of the concepts shown here will be familiar to anyone with a knowledge of mainstream macroeconomics. However, the field of macroeconomics has multiple schools of thought, and they disagree with each other on some topics.

This tutorial's content is most influenced by a branch of economics sometimes referred to as Modern Monetary Theory (MMT) or neo-Chartalism, a part of the larger heterodox Post-Keynesian school. Here are some of its characteristics:

  • It is rooted in a deep knowledge of the modern operational realities of our economic systems (the banking system, the Federal government, etc).
  • It incorporates the standard accounting practices (double-entry bookkeeping) that businesses and governments use every day and is logically stock-flow consistent.
  • It has been around for decades, yet only since the global economic crisis has this branch of economics really begun to achieve wider-spread recognition, largely because of how well it explains recent economic history.
  • It cleanly separates politics from economics. The concepts covered here are equally compatible with political choices favoring either large or small government.
  • It recognizes the importance of focusing on flows of net worth within the economy rather than just focusing on quantities of individual asset types in isolation, and it models all financial assets (including money) as the dynamic liabilities that they are, rather than as if they were commodities.

Bibliography and Links

Sources for additional information on these topics:

Excerpt from Unconventional monetary policies: an appraisal by Claudio Borio and Piti Disyatat of the Bank for International Settlements (BIS)

"The underlying premise of the first proposition, which posits a close link between reserves expansion and credit creation, is that bank reserves are needed for banks to make loans. Either bank lending is constrained by insufficient access to reserves or more reserves can somehow boost banks' willingness to lend. An extreme version of this view is the text-book notion of a stable money multiplier: central banks are able, through exogenous variations in the supply of reserves, to exert a direct influence on the amount of loans and deposits in the banking system.

"In fact, the level of reserves hardly figures in banks' lending decisions. The amount of credit outstanding is determined by banks' willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly. The reason is simple: as explained in Section I, under scheme 1 - by far the most common - in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system. From this perspective, a reserve requirement, depending on its remuneration, affects the cost of intermediation and that of loans, but does not constrain credit expansion quantitatively..."

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