## Wednesday, April 05, 2023

### The Importance of Teaching Fractional Reserve Banking

I was recently chatting with someone who teaches introductory macroeconomics (not using my favorite textbook). He does not teach the students about money creation under fractional reserve banking, which he considers an unnecessary technicality, but he does teach them the following two statements about inflation.

1. If the Fed lowers the interest rate on reserves, that policy stimulates economic activity in the short run and, via the Phillips curve, increases inflation.
2. In the long run, the quantity theory of money explains inflation.

I agree with both of these statements, and I consider them critical for students to understand. But consider: How does one explain the transition from the short run to the long run?

The only way I know to answer this question is that a lower interest rate on reserves increases bank lending and expands the money supply by increasing the money multiplier. But if students don’t know about how banks create money under fractional reserve banking, they are not equipped to understand this logic.

The bottom line: The traditional pedagogy about how banks influence the money supply remains important if students are to understand the economics of inflation.

Update: This post generated more than the usual amount of confusion and misdirection on Twitter. So let me explain my logic more slowly:

1. It is useful to teach the quantity theory of money (M and P are parallel) as a long-run equilibrium condition, regardless of which direction causality runs.
2. It is useful for students to know that cutting the interest rate on reserves is expansionary for aggregate demand and, over time, inflationary. That is, it raises P.
3. To complete the story, you need to explain how cutting the interest rate on reserves raises M.
4. To be sure, lower interest rates increase the quantity of money demanded. But you also must explain the quantity of money supplied.
5. The money supply M equals m*B, where m is the money multiplier and B is the monetary base (currency plus reserves).
6. Cutting the interest on reserves (unlike open-market operations) does not change B. So if it changes the money supply M, it must work through the money multiplier m.
7. One cannot understand the money multiplier m without understanding fractional reserve banking. (Under 100-percent-reserve banking, m is fixed at 1.)