The economy grows for multiple reasons, but one is the multiplier effect due to fractional reserve banking.

When there is a crash, is that artificially created money essentially destroyed, resetting the economy to how much money is "really" in the system?

Sorry, I know this may be phrased informally but my knowledge of economics is limited. I just know that a crash is regarded as an economic "reset", while "multiplying" money is artificial and depends on the market's confidence.

(originally posted here, I hope at least one of these forums is the correct place: https://money.stackexchange.com/questions/77099/is-a-market-crash-the-undoing-of-the-multiplier-effect)

  • $\begingroup$ When you say market crash, do you mean a stock market crash? If not, what do you mean. Please clarify in the body of the question. $\endgroup$ – BKay Mar 9 '17 at 17:55
  • $\begingroup$ Subject line updated. Yes I guess I mean stock market if that is driven in part by the multiplier effect (again, my knowledge is limited so please work with me). $\endgroup$ – Sridhar Sarnobat Mar 9 '17 at 19:09
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    $\begingroup$ Maybe a repeat of this question: economics.stackexchange.com/questions/13312/… $\endgroup$ – Mick Mar 9 '17 at 20:36

All price changes in the stock or commodities markets impact the money supply to the extent it results in a change in margin credit. Do note that the amount of credit itself must change and not the price alone. A crash only has an impact if it results in net changes in the amount of credit.

This is a second order effect of a crash and not a first order effect. It also usually has no material impact on the money supply. Although a crash may have a large impact on notional concepts of wealth, the effect on the supply of money itself is usually neutralized by the banking system. It is normal, even in the 1929 crash, to see bankers announce they will keep open the brokerages' lines of credit and stand ready to purchase safe assets such as Treasuries in unlimited quantities from these brokers to hold the money supply roughly constant. If brokers sold enough treasuries, it could even expand the money supply.

The size of the money stock (M2) is 13.4 trillion dollars. The total size of all margin credit from all sources is 554 billion dollars. Although this is four percent of the money supply, which is a lot, you are also forgetting that in a crash margin purchases will begin happening too. Just as brokerages will be issuing margin calls, other investors smelling blood in the water will be purchasing on margin, though this will be a smaller effect.

The Fed normally drops the interest rate to expand the money supply after a crash to compensate for the loss of money created by the reduction in margin credit. Remember that 554 billion would not be wiped out in a crash, it would just be reduced, at least initially, as brokers required repayment.

  • $\begingroup$ Thanks for the info, it's a bit much for me to digest but I'll keep rereading it until I get it $\endgroup$ – Sridhar Sarnobat Mar 25 '17 at 18:45

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