Suppose that you’re living in a city that requires a medallion to operate a taxi. Unlike New York, however, your city doesn’t sell permanent medallions. Instead, it distributes temporary medallions that last only a year, and those medallions trade at some price. How does the number of medallions influence the number of taxis?
If you were a budding macroeconomist, you might conjecture the existence of a “taxi multiplier” of one: as the city increases the supply of medallions, the number of taxis on the street increases by precisely the same amount. And in fact, this would be an extraordinarily accurate way of describing the data. As long as they’re constrained by the supply of medallions, the city’s taxi operators will put exactly enough taxis on the street to use up all the medallions. There will be no excess medallions floating around.
Now suppose that the city dramatically increases the supply of medallions, flooding the market. Will the “taxi multiplier” still hold?
At first, yes. As long as taxi operators are still constrained by the scarcity of medallions—or, equivalently, as long as medallions trade at a price above zero—the number of taxis will be exactly equal to the number of medallions. At some point, however, the number of medallions will exceed the number of taxis that it’s economical to put on the streets, no matter how little the medallions cost. (After all, cities without medallions don’t have an infinite number of taxis.) At this point, there will be no scarcity, the price of medallions will plummet to zero, and the “taxi multiplier” will cease to be operational. In fact, any further decisions to increase the supply of medallions will have zero impact on the city’s taxi fleet. The number of taxis is pinned down by the supply and demand for their services.
It’s instructive to think about the “money multiplier” in the same way. Up to a point, bank reserves are precisely tied to the amount held in checking accounts: since the required ratio is 10%, any increase in bank reserves will be mirrored by a 10-fold increase in checking account balances. There are no excess reserves. At some point, however, the Fed will increase the supply of bank reserves to such an extent that they’re no longer a binding constraint on the ability to put money in checking accounts. The cost of holding reserves will plummet to zero (as the fed funds rate falls to the rate paid on reserves), and checking account balances will be determined entirely by other factors: consumers’ desire for liquidity, consumers’ assets, the cost of financial intermediation, and so on. At the margin, there is no longer any money multiplier, at least in the textbook sense.
This isn’t to say, of course, that the Fed is powerless to affect the economy. But the “bank lending channel”, where an increase in the supply of reserves leads banks to accept more deposits and lend them out, cannot possibly have any impact.
As long ago as 1995, Bernanke and Gertler described a model of this channel as a “poorer description of reality than it used to be”. After the US eliminated every reserve requirement except the 10% on checking accounts, the direct impact of reserve supply on the amount of financial intermediation in the economy became questionable at best. But now that the interest rate on reserves is (more or less) the same as the federal funds rate, holding reserves to back deposits has become costless—and just as the taxi multiplier disappears when the price hits zero, the money multiplier ceases to be relevant.