The Money Multiplier is neat, plausible – and utterly wrong!

30 July, 2012 at 17:44 | Posted in Economics | 4 Comments

The neoclassical textbook concept of money multiplier assumes that banks automatically expand the credit money supply to a multiple of their aggregate reserves.  If the required currency-deposit reserve ratio is 5%, the money supply should be about twenty times larger than the aggregate reserves of banks.  In this way the money multiplier concept assumes that the central bank controls the money supply by setting the required reserve ratio.

In his Macroeconomics (6th ed, 2007) – just to take an example – Greg Mankiw writes (p. 514):

We can now see that the money supply is proportional to the monetary base. The factor of proportionality … is called the money multiplier … Each dollar of the monetary base produces m dollars of money. Because the monetary base has a multiplied effect on the money supply, the monetary base is called high-powered money.

The money multiplier concept is – as can be seen from the quote above – nothing but one big fallacy. This is not the way credit is created in a monetary economy. It’s nothing but a monetary myth that the monetary base can play such a decisive role in a modern credit-run economy with fiat money.

In the real world banks first extend credits and then look for reserves. So the money multiplier basically also gets the causation wrong. At a deep fundamental level the supply of money is endogenous.

Although lately we’ve had our quarrels over microfoundations of macroeconomics, it seems as though Simon Wren-Lewis and yours truly at least agree on the money multiplier concept. Wren-Lewis has a nice piece on the subject on his blog today: 

[T]his does raise a rather embarrassing question for macroeconomists – why is the money multiplier still taught to many undergraduates? Why is it still in the textbooks? …

[One] response is that there is no harm in including the money multiplier … But I think it also does harm, because it gives the impression that banks are passive, just translating savings into investment via loans. If it is taught properly, it also leaves the student wondering what on earth is going on. They take the trouble to learn and understand the formula, and then discover that in the last few years central banks have been expanding the monetary base like there is no tomorrow and the money supply has hardly changed! …

I think I know why it is still in the textbooks. It is there because the LM curve is still part of the basic macro model we teach students. We still teach first year students about a world where the monetary authorities fix the money supply. And if we do that, we need a nice little story about how the money supply could be controlled. Now, just as is the case with the money multiplier, good textbooks will also talk about how monetary policy is actually done, discussing Taylor rules and the like. But all my previous arguments apply here as well. Why waste the time of, and almost certainly confuse, first year students this way? …

Many students who go on to become economists are put off macroeconomics because it is badly taught. Some who do not go on to become economists end up running their country! So we really should be concerned about what we teach. So please, anyone reading this who still teaches the money multiplier, please think about whether you could spend the time teaching something that is more relevant and useful.

About these ads

4 Comments »

RSS feed for comments on this post. TrackBack URI

  1. And what about budget deficits causing interest rates to rise? Shall it be gone as well then?

  2. Here’s a good quote from Marc Lavoie on the subject (http://www.levyinstitute.org/pubs/conf_june10/LaVoie2.pdf):
    You seem to imply that the textbook multiplier still applies when reserves earn no interest. I think that this is a misleading statement. It implies that there is a bunch of agents out there, waiting for banks to provide them with loans, but that there are being credit rationed because banks don’t have access to free reserves. …Rather what happens when excess reserves are being provided with no remuneration of reserves is that the fed funds rate drops down, as banks with surplus reserves despair to find banks with insufficient reserves, having no alternative but a zero rate. The drop in the fed funds rate may induce banks to lower their lending rates, and hence induce new borrowers to ask for loans or bigger loans, but it really has nothing to do with the standard multiplier story. If there is no change in the lending rate, new creditworthy borrowers just won’t show up. There is never any money multiplier effect.

    Ramanan alerted me to the quote in comments here http://bubblesandbusts.blogspot.com/2012/06/ior-killed-money-multiplier.html

  3. The weird thing is that the money multiplier is not a causal relationship. How did the “heterodox” get this so wrong? The idea behind the money multiplier is that there are a hell of a lot of more money out there than the coins and bills people hold in their wallets. And the money multiplier tells you how that can happen.

    “In the real world banks first extend credits and then look for reserves”.

    That’s just a non-argument. What matters is that there are cost associated with holding reserves. So paying those costs before or after credits are extended is irrelevant (and in fact coincides exactly in a full information world). So why would you claim the timing matters? To me it’s like saying that in restaurant you eat FIRST, and THEN pay the bill. Yeah, it doesn’t make much of a difference when you decided whether to eat out or not.

    • I teach introductory macro, and yes, the money multiplier is presented as a causal relationship. I teach at a University with 40000 undergraduates

      “And the money multiplier tells you how that can happen.”

      No, it does not, because the reserve requirements described as a constraint in the money multiplier story are not a true constraint


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Create a free website or blog at WordPress.com. | The Pool Theme.
Entries and comments feeds.