Multiple Effect of Money
Fractional reserve banking places a fundamental role in the multiplication of money. The feds or the equivalent central banks are the one who determines the reserve ratio for banks. which is the minimum amount of deposits that banks must hold in liquid securities in order to meet their obligations.
This stock of money that is kept in near term deposit refers to what we call M1 money supply. It’s the money that includes, coins, notes in circulation and other money equivalent that can be easily converted.
As everyone knows, banks have the right to give loans to their customers, therefore increase the broad money supply in the monetary system, Here is a concrete example..
For example if the federal reserve requirement is 5%, The banks have the obligation to hold only 5% of their balance sheet in their reserves.
The other 95% is free to give it as a loan, Which means that banks could lend out 20 times the amount of money that is kept their reserves. This is what we call the money multiplier effect, which means that the money that exists in the economy could be a many multiples of the money that actually exists in the banks.
Beside M1 money supply, You would hear about M2, M3 and MZM (Money Zero Maturity ) money supply.
M0 and M1 are the narrow money and it include coins, notes that are in circulation and other money equivalent that can be easily converted to cash.
M2 includes M1 and short terms time deposits in banks and certain market funds.
M3 includes M2 in addition to long terms deposits.
At last, there is the MZM, or money zero maturity which includes financial assets with zero maturity which are immediately redeemable. The federal reserve bank relies heavily on the MZM data because its velocity is a proven indicator of inflation.
The chart above shows the evolution of the M1, M2 money supply over the past years. The spike within both M1 and M2 happens only during the Covid pandemic, which had a massive impact over the money board money supply. Was it because the feds printed more money? Yes, that’s the slight tick over M1 supply, but the M2 spike is related to another factor.
The federal bank have usually three tools at their disposal to impact boarder money supply.
Fed Funds Rate
Open Market Operations
In order for the feds to increase the economy money supply, They have to increase the reserve ratio. vice versa for a contraction of money supply.
The reserve ratio itself ranges from 3% to 10% for number of years, this made sure that banks had reserves that are broadly inlines with their activity, the banks who are viewed riskier, had to hold more reserves therefore, more restricted in their ability to create money.
Here is the end of story for the reserve ratio. Along the global pandemic, in Mars 2020, the feds had to drop the reserve ratio to 0% for all banks. In other words, they eliminate any needs for reserves at all.
The banks are not really required to keep reserves in order to meet withdraw request, they can effectively loan out as much money as they want into the economy therefore inflating the M2 money supply.
Here is a fun fact, almost the 5th of all US money supply in existence was created in 10 months in year 2020.
Excess money Vs Limited goods
When free money and easy credits are out in the monetary system, It’s quite hard to bring them back in without economic damage. That’s because flooding the system with an excess of money supply that chases limited goods, would lead to a pretty crazy levels of inflation.
Decentralization hence, blockchain would be the key for a better economy.