NY Fed staff: The banking system no longer resembles the fractional reserve banking model

In an article last year, economist Marc Lavoie noted that the financial crisis and the reaction to it have forced monetary authorities to publicly reject some key assumptions of mainstream monetary theory as a way to prevent market participants from misrepresenting and misjudging the effects of recent Fed actions. According to Lavoie, these features of mainstream theory include the notion that increases in bank reserves get "multiplied" into a larger expansion in the broad money supply as banks increase lending, as well as the idea that increases in bank reserves at the central bank result in price inflation.

As these recent blog entry and working paper by NY Fed staff can attest, it's clear that the Fed's public relations campaign to change people's understanding of all this is still underway. No doubt, these efforts are also partly aimed at countering the views recently expressed by certain economists within the Federal Reserve System regarding the potentially inflationary nature of an expanded monetary base.

That being said, I find the title of McAndrews's blog entry misleading. I fail to see how disproving the money multiplier means QE isn't inflationary. In my view, there is a good case to be made that the Fed's asset purchase has ramped up the search for yields, leading banks into speculation resulting in, for instance, commodity inflation. However, the inflationary potential of QE should be viewed as a separate issue given that the resultant inflation would not be a consequence of increased lending caused by the increase in bank reserves.

Here is an interesting excerpt from the working paper by McAndrews et al. explaining how the Fed's authority to pay interest on reserves nullifies the money multiplier process and the notion of fractional reserve banking:

In this note, we present a basic model of the current U.S. banking system, in which interest is paid on bank reserves and there are no binding reserve requirements. We find that, absent any frictions, lending is unaffected by the amount of reserves in the banking system. The key determinant of bank lending is the difference between the return on loans and the opportunity cost of making a loan. We show that this difference does not depend on the quantity of reserves. [...] The current banking system in the United States and worldwide no longer resembles the traditional textbook model of fractional reserve banking. Historically, the quantity of reserves supplied by a central bank determines the amount of bank loans. Through the "money multiplier", banks expand loans to equal the amount of reserves divided by the reserve requirement. However, in many countries, reserve requirements have been reduced either to zero, or to such small levels that they are no longer binding. (p. 1)