Banks are Capital Constrained, Not Reserve Constrained

Generations of economics students have been misled into believing that banks are reserve constrained. Even today, though most specialist monetary economists would likely cringe at the idea, there are widely used textbooks that teach this mistaken view to a new generation of students. Usually the story is framed in terms of a ‘money multiplier’ model in which an addition of reserves into the monetary system by the central bank will supposedly cause a multiplied increase in bank lending and in doing so expand the ‘money supply’ (in this context meaning currency plus deposits). In reality, banks create deposits (add to the money supply) in the act of lending. If they subsequently find themselves short of reserves, they can obtain them from other banks or, in the event of a system-wide shortage, they can borrow them from the central bank which is committed to acting as lender of last resort, a function that it must perform under present institutional arrangements to ensure smooth functioning of the system. The constraint on bank lending is profitability and bank capital, not reserves.

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