Money, Reserves, and the Transmissi

Money, Reserves, and the Transmission of Monetary Policy:
Does the Money Multiplier Exist?

With the use of nontraditional policy tools, the level of reserve balances has risen significantly in
the United States since 2007. Before the financial crisis, reserve balances were roughly $20
billion whereas the level has risen well past $1 trillion. The effect of reserve balances in simple
macroeconomic models often comes through the money multiplier, affecting the money supply
and the amount of bank lending in the economy. Most models currently used for
macroeconomic policy analysis, however, either exclude money or model money demand as
entirely endogenous, thus precluding any causal role for reserves and money. Nevertheless,
some academic research and many textbooks continue to use the money multiplier concept in
discussions of money. We explore the institutional structure of the transmission mechanism
beginning with open market operations through to money and loans. We then undertake
empirical analysis of the relationship among reserve balances, money, and bank lending. We use
aggregate as well as bank-level data in a VAR framework and document that the mechanism
does not work through the standard multiplier model or the bank lending channel. In particular,
if the level of reserve balances is expected to have an impact on the economy, it seems unlikely
that a standard multiplier story will explain the effect.

Introduction
A second issue involves the effect of the large volume of reserves created as we buy
assets. [. . .] The huge quantity of bank reserves that were created has been seen largely
as a byproduct of the purchases that would be unlikely to have a significant independent
effect on financial markets and the economy. This view is not consistent with the simple
models in many textbooks or the monetarist tradition in monetary policy, which
emphasizes a line of causation from reserves to the money supply to economic activity
and inflation. . . . [W]e will need to watch and study this channel carefully.
Donald L. Kohn, Vice Chairman of the Federal Reserve Board, March 24, 2010
The Federal Reserve’s implementation of a range of nontraditional monetary policy
measures to combat a severe financial crisis and a deep economic recession resulted in a very
large increase in the level of reserve balances in the U.S. banking system. As a result, there has
been renewed interest in the transmission of monetary policy from reserves to the rest of the
economy. Since the 1980s, two broad transmission mechanisms have been discussed: an
“interest-rate” or “money channel,” in which interest rates adjust to clear markets and influence
borrowing and lending behavior; and a “credit channel,” in which the quantity as much as the
price of loanable funds transmit monetary policy to the economy. Within the credit channel
literature, a narrow “bank lending channel” view of the world follows the textbook money
multiplier taught in undergraduate textbooks and suggests that changes in open market
operations and the quantity of reserves directly affect the amount of lending that banks can do. A textbook money multiplier and the bank lending channel imply an important role for
money in the transmission mechanism. In the past couple of decades however, New Keynesian
models used for macroeconomic policy analysis have excluded money. The exceptions in this
class of models are those where a money demand equation is appended, and the quantity of
money is entirely endogenously determined with no feedback to real variables. This extreme
marginalization of money is not universal, however. Some researchers for example, Hafer,
Haslag, and Jones (2007), Leeper and Roush (2003), Ireland (2004), Meltzer (2001) and most notably, the European Central Bank, put serious weight on the role of money in the
macroeconomy and policy analysis. Indeed, at the other extreme, many economics textbooks
and some academic research, such as Freeman and Kydland (2000) or Diamond and Rajan
(2006) continue to refer to the very narrow money multiplier and accord it a principle role in the
transmission of monetary policy.
The recent rise in reserve balances suggests a need to reassess the link from reserves to
money and to bank lending. We argue that the institutional structure in the United States and
empirical evidence based on data since 1990 both strongly suggest that the transmission
mechanism does not work through the standard money multiplier model from reserves to money
and bank loans. In the absence of a multiplier, open market operations, which simply change
reserve balances, do not directly affect lending behavior at the aggregate level.1 Put differently,
if the quantity of reserves is relevant for the transmission of monetary policy, a different mechanism must be found. The argument against the textbook money multiplier is not new. For
example, Bernanke and Blinder (1988) and Kashyap and Stein (1995) note that the bank lending
channel is not operative if banks have access to external sources of funding. The appendix
illustrates these relationships with a simple model. This paper provides institutional and
empirical evidence that the money multiplier and the associated narrow bank lending channel are
not relevant for analyzing the United States.

Bank Balance Sheets
In discussing the money multiplier, we must first define money. For better or worse,
most economists think of M2 as the measure of money. M2 is defined as the sum of currency,
checking deposits, savings deposits, retail money market mutual funds, and small time deposits.
Since 1992, the only deposits on depository institutions’ balance sheets that had reserve
requirements have been transaction deposits, which are essentially checking deposits.5 As noted
above, the majority of M2 is not reservable and money market mutual funds are not liabilities of
depository institutions. Nevertheless, it is the link between money and reserves that drives the
theoretical money multiplier relationship. As a result, the standard multiplier cannot be an important part of the transmission mechanism because reserves are not linked to most of M2.
For perspective, M2 averaged about $7¼ trillion in 2007. In contrast, reservable deposits
were about $600 billion, or about 8 percent of M2. Moreover, bank loans for 2007 were about
$6¼ trillion.6 This simple comparison suggests that reservable deposits are in no way sufficient to fund bank lending. Indeed, if we consider the fact that reserve balances held at the Federal
Reserve were about $15 billion and required reserves were about $43 billion, the tight link drawn
in the textbook transmission mechanism from reserves to money and bank lending seems all the
more tenuous. Figure 2 plots required reserves with M2 (both panels), and there is no
relationship. M2 trends upward, growing in nominal terms with the economy. Required
reserves, however, fell dramatically just after 1990 following the reduction in required reserve
ratios and trended down through 2000, largely as retail sweep programs allowed depository
institutions to reduce their reserve requirements. The fact that only a very small fraction of M2
is reservable explains the disconnect between money, measured as M2, and required reserves.
Bank loans are shown as the dashed line in the upper panel and have a similar trend to that of
M2. Of course trending nominal variables will often exhibit spurious correlation, but it is clear that there is no link between reserves and loans.7
Further complicating the story is the fact that required reserves and the reserves held by
banks at the Federal Reserve, which we refer to as reserve balances, are different concepts.8 The
lower panel in Figure 2 shows the level of reserve balances as the dotted line. It too bears little if
any relationship to the pattern of M2. Open market operations adjust the level of reserve
balances, so to understand the transmission mechanism, we want to ask if there is a direct link
from reserve balances to money or lending. Institutional detail and casual empiricism clearly
point away from the textbook money multiplier as a relevant concept for understanding the
effects of open market operations on money and bank lending.

An Empirical Look at the Traditional Transmission Mechanism
We turn now to econometric analysis of the transmission mechanism of monetary policy
as a different way to examine the money multiplier. Although the real side of the transmission
mechanism is clearly important, the real side has received, and continues to receive, a great deal
of attention, and so this paper will not address which sectors of the economy are affected by
monetary policy. Nevertheless, to avoid misspecifying endogenous monetary policy in the
empirical work, we include standard measures of economic activity. In a similar vein, we do not
address the yield-curve implications of the transmission of monetary policy. While these
concerns are clearly important, our focus is a bit narrower, examining the transmission mechanism from open market operations to money and bank lending. We appeal to Granger
causality tests and vector autoregressions (VARs) to let the data summarize the relationships
involved.

Aggregate Analysis at the Monthly Frequency
i) Granger Causality Tests
As a first look at the transmission mechanism, we run some Granger-causality tests of
deposits, bank loans, and balances of depository institutions at the Federal Reserve at a monthly
frequency. The data appendix provides more detail about these variables. Consider the
following aggregated, simplified balance sheet of the banking system:

tabel

Managed liabilities refer to deposits that can be increased or decreased at will, such as
large, or wholesale, time deposits, Eurodollar and other Eurocurrency borrowings, repos, and
federal funds purchased to meet a bank’s needs for funds to pay off maturing deposits and to
fund new loans.
We run the Granger causality tests in both log levels a

Hasil (Bahasa Indonesia) 1:

Uang, cadangan, dan transmisi kebijakan moneter:Apakah ada uang Multiplier?Dengan menggunakan alat-alat kebijakan nontradisional, tingkat saldo cadangan telah meningkat secara signifikan diAmerika Serikat sejak tahun 2007. Sebelum krisis keuangan, cadangan saldo yang kira-kira $20miliar sedangkan tingkat telah meningkat baik melewati $1 triliun. Efek dari cadangan Saldo sederhanamodel makroekonomi sering datang melalui uang multiplier, mempengaruhi jumlah uang beredardan jumlah pinjaman bank dalam perekonomian. Kebanyakan model saat ini digunakan untukAnalisis kebijakan makroekonomi, bagaimanapun, baik mengecualikan uang atau model permintaan uang sebagaisepenuhnya endogen, sehingga menghalangi peran apa pun kausal untuk cadangan dan uang. Namun demikian,beberapa penelitian akademis dan banyak buku terus menggunakan uang multiplier konsep dalamdiskusi uang. Kita menjelajahi struktur kelembagaan mekanisme transmisidiawali dengan melalui operasi pasar terbuka untuk uang dan pinjaman. Kami kemudian melakukanAnalisis empiris hubungan antara cadangan saldo, uang dan pinjaman bank. Kami menggunakanagregat serta bank level data dalam kerangka VAR dan dokumen yang mekanismetidak bekerja melalui model standar pengganda atau bank pinjaman saluran. Secara khusus,Jika tingkat saldo cadangan yang diharapkan memiliki dampak pada ekonomi, tampaknya tidak mungkinbahwa cerita standar pengganda akan menjelaskan efek.IntroductionA second issue involves the effect of the large volume of reserves created as we buyassets. [. . .] The huge quantity of bank reserves that were created has been seen largelyas a byproduct of the purchases that would be unlikely to have a significant independenteffect on financial markets and the economy. This view is not consistent with the simplemodels in many textbooks or the monetarist tradition in monetary policy, whichemphasizes a line of causation from reserves to the money supply to economic activityand inflation. . . . [W]e will need to watch and study this channel carefully.Donald L. Kohn, Vice Chairman of the Federal Reserve Board, March 24, 2010The Federal Reserve’s implementation of a range of nontraditional monetary policymeasures to combat a severe financial crisis and a deep economic recession resulted in a verylarge increase in the level of reserve balances in the U.S. banking system. As a result, there hasbeen renewed interest in the transmission of monetary policy from reserves to the rest of theeconomy. Since the 1980s, two broad transmission mechanisms have been discussed: an“interest-rate” or “money channel,” in which interest rates adjust to clear markets and influenceborrowing and lending behavior; and a “credit channel,” in which the quantity as much as theprice of loanable funds transmit monetary policy to the economy. Within the credit channelliterature, a narrow “bank lending channel” view of the world follows the textbook moneymultiplier taught in undergraduate textbooks and suggests that changes in open marketoperations and the quantity of reserves directly affect the amount of lending that banks can do. A textbook money multiplier and the bank lending channel imply an important role formoney in the transmission mechanism. In the past couple of decades however, New Keynesianmodels used for macroeconomic policy analysis have excluded money. The exceptions in thisclass of models are those where a money demand equation is appended, and the quantity ofmoney is entirely endogenously determined with no feedback to real variables. This extrememarginalization of money is not universal, however. Some researchers for example, Hafer,Haslag, and Jones (2007), Leeper and Roush (2003), Ireland (2004), Meltzer (2001) and most notably, the European Central Bank, put serious weight on the role of money in themacroeconomy and policy analysis. Indeed, at the other extreme, many economics textbooksand some academic research, such as Freeman and Kydland (2000) or Diamond and Rajan(2006) continue to refer to the very narrow money multiplier and accord it a principle role in thetransmission of monetary policy.The recent rise in reserve balances suggests a need to reassess the link from reserves tomoney and to bank lending. We argue that the institutional structure in the United States andempirical evidence based on data since 1990 both strongly suggest that the transmission
mechanism does not work through the standard money multiplier model from reserves to money
and bank loans. In the absence of a multiplier, open market operations, which simply change
reserve balances, do not directly affect lending behavior at the aggregate level.1 Put differently,
if the quantity of reserves is relevant for the transmission of monetary policy, a different mechanism must be found. The argument against the textbook money multiplier is not new. For
example, Bernanke and Blinder (1988) and Kashyap and Stein (1995) note that the bank lending
channel is not operative if banks have access to external sources of funding. The appendix
illustrates these relationships with a simple model. This paper provides institutional and
empirical evidence that the money multiplier and the associated narrow bank lending channel are
not relevant for analyzing the United States.

Bank Balance Sheets
In discussing the money multiplier, we must first define money. For better or worse,
most economists think of M2 as the measure of money. M2 is defined as the sum of currency,
checking deposits, savings deposits, retail money market mutual funds, and small time deposits.
Since 1992, the only deposits on depository institutions’ balance sheets that had reserve
requirements have been transaction deposits, which are essentially checking deposits.5 As noted
above, the majority of M2 is not reservable and money market mutual funds are not liabilities of
depository institutions. Nevertheless, it is the link between money and reserves that drives the
theoretical money multiplier relationship. As a result, the standard multiplier cannot be an important part of the transmission mechanism because reserves are not linked to most of M2.
For perspective, M2 averaged about $7¼ trillion in 2007. In contrast, reservable deposits
were about $600 billion, or about 8 percent of M2. Moreover, bank loans for 2007 were about
$6¼ trillion.6 This simple comparison suggests that reservable deposits are in no way sufficient to fund bank lending. Indeed, if we consider the fact that reserve balances held at the Federal
Reserve were about $15 billion and required reserves were about $43 billion, the tight link drawn
in the textbook transmission mechanism from reserves to money and bank lending seems all the
more tenuous. Figure 2 plots required reserves with M2 (both panels), and there is no
relationship. M2 trends upward, growing in nominal terms with the economy. Required
reserves, however, fell dramatically just after 1990 following the reduction in required reserve
ratios and trended down through 2000, largely as retail sweep programs allowed depository
institutions to reduce their reserve requirements. The fact that only a very small fraction of M2
is reservable explains the disconnect between money, measured as M2, and required reserves.
Bank loans are shown as the dashed line in the upper panel and have a similar trend to that of
M2. Of course trending nominal variables will often exhibit spurious correlation, but it is clear that there is no link between reserves and loans.7
Further complicating the story is the fact that required reserves and the reserves held by
banks at the Federal Reserve, which we refer to as reserve balances, are different concepts.8 The
lower panel in Figure 2 shows the level of reserve balances as the dotted line. It too bears little if
any relationship to the pattern of M2. Open market operations adjust the level of reserve
balances, so to understand the transmission mechanism, we want to ask if there is a direct link
from reserve balances to money or lending. Institutional detail and casual empiricism clearly
point away from the textbook money multiplier as a relevant concept for understanding the
effects of open market operations on money and bank lending.

An Empirical Look at the Traditional Transmission Mechanism
We turn now to econometric analysis of the transmission mechanism of monetary policy
as a different way to examine the money multiplier. Although the real side of the transmission
mechanism is clearly important, the real side has received, and continues to receive, a great deal
of attention, and so this paper will not address which sectors of the economy are affected by
monetary policy. Nevertheless, to avoid misspecifying endogenous monetary policy in the
empirical work, we include standard measures of economic activity. In a similar vein, we do not
address the yield-curve implications of the transmission of monetary policy. While these
concerns are clearly important, our focus is a bit narrower, examining the transmission mechanism from open market operations to money and bank lending. We appeal to Granger
causality tests and vector autoregressions (VARs) to let the data summarize the relationships
involved.

Aggregate Analysis at the Monthly Frequency
i) Granger Causality Tests
As a first look at the transmission mechanism, we run some Granger-causality tests of
deposits, bank loans, and balances of depository institutions at the Federal Reserve at a monthly
frequency. The data appendix provides more detail about these variables. Consider the
following aggregated, simplified balance sheet of the banking system:

tabel

Managed liabilities refer to deposits that can be increased or decreased at will, such as
large, or wholesale, time deposits, Eurodollar and other Eurocurrency borrowings, repos, and
federal funds purchased to meet a bank’s needs for funds to pay off maturing deposits and to
fund new loans.
We run the Granger causality tests in both log levels a