Sunday, December 28, 2008

Credit Multiplier

Textbook teaching on the creation of money and credit usually describes an increase in the supply of money. Here is an example in an article prepared by an economist at a reputable central bank. She describes a situation where a deposit of $1,000 that comes into a bank from outside becomes $10,000 within the banking system. She assumed a credit multiplier of 10, but if the level of reserves held by the banks the lower, the credit multiplier would be even larger. More money must be good, so all this seems to be quite benign to a student of economics.

Textbooks rarely illustrate the opposition situation where $1,000 is taken out of a bank and the system loses $10,000. This is not quite so nice, but it is relevant to the current situation. If a bank has to write off a bad loan, its capital is reduced by the amount of the loan. The credit multiplier kicks in and reduces the money in the banking system by 10 times as much as was lost by the bank. This is sometimes called deleveraging. The credit multiplier can easily become a credit cruncher.


Jim Fedako said...

You are close, but not correct on the credit write-off.

Since financial institutions are subject to debt-equity ratios, a loss of capital may force a bank to recall loans. But it is the recall of loans -- the payment of loans -- that destroys money, not the write-off itself.

In addition, the central bank can destroy money by selling assets to financial institutions.

Great article over at

Ron McK said...

Thanks Jim. Good Article.

I was not really trying to explain the process, just noting that mainstream economics texts just describe the expansion phase. The ignore contraction multiplier, even though it is more important.