Principles of Macroeconomics / Unit 12 MAC 1136 review, 2 to 3 minutes
Two Regimes, One Institution
The idea
This unit has taught two different accounts of how a central bank works, and they are not a contradiction, so it is worth separating them deliberately. In the limited-reserves regime, reserves are scarce and earn nothing. The central bank changes their quantity, banks shed any excess because holding it is costly, lending expands or contracts, and the money multiplier of unit eleven describes the result. In the ample-reserves regime, reserves are abundant and they pay interest. Changing their quantity by a little does nothing, because there is already far more than banks need, and a bank has no reason to shed reserves that earn a return. So the central bank sets the rate it pays on reserves instead, and the federal funds rate tracks it. The first regime steers a quantity; the second steers a price. What changed was not the theory but the conditions the theory assumed, and the change happened for a reason: reserves grew from about fifteen billion dollars in 2007 to trillions, and interest began to be paid on them in 2008.
In practice
Worked example, the same action under both regimes. The central bank buys 200 of bonds from unit eleven's bank. Under limited reserves, the bank's reserves rise above the level it wants, and because those reserves earn nothing it lends the excess; loans rise, deposits rise, and the money supply expands by a multiple through the lending chain. Under ample reserves, the bank's reserves rise and it already held far more than it needed, and the reserves pay the policy rate, so it may keep them. Loans need not move at all. The identical transaction produces a multiplied expansion in one regime and possibly nothing in the other, and the difference is entirely in what reserves earn and how many there already are.
Where people slip
Three cautions for the exam and beyond. First, the limited-reserves model is still examinable and the outline still asks for banks and the creation of money, so learn it, and learn it labelled: the anchor's own appendix names its regime on its face, and unit eleven's multiplier belongs to the same regime. Second, with the required ratio at zero the expression one divided by the ratio has no finite value, which is a signal that the binding constraints are now elsewhere — a bank's capital, its own risk judgement, and what it is paid to hold reserves. Third, regimes change again. The useful thing to carry forward is not which one is current but the habit of asking what a model assumes about scarcity and about what an asset earns, because those two questions are what separated these two.
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