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The Money Multiplier & Loanable Funds

November 28, 2011

The “money multiplier” and “loanable funds” models are wrong. What’s wrong with them is not just that they don’t describe how banks actually work: they get the nature of money wrong as well. They’re dependent on an understanding of money as an asset, and asset only – like gold. Modern money works differently. It is always an asset to one party, and a liability to someone else. Commercial bank deposits are liabilities on a commercial bank – and assets to the public. Central bank deposits are liabilities on a central bank – and assets to commercial banks.

In no case is there a preexisting pool of money, and in no case is there any physical limit to the amount of money that may be lent. The process – or act – of lending actually creates the money that is lent. Lending precedes deposits, because without lending, there is no money to deposit.

Banks can create indefinite amounts of money so long as there are willing customers and opportunities to make profits. A central bank – by reducing reserves – can drive up interest rates, but that’s all.

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