The money multiplier – neat, plausible, and utterly wrong

28 April, 2016 at 18:02 | Posted in Economics | 9 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 – just to take an example – Greg Mankiw writes:

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.

garbageOne may rightly wonder why on earth this pet neoclassical fairy tale is still in the textbooks and taught to economics undergraduates. Giving the impression that banks exist simply to passively transfer savings into investment, it is such a gross misrepresentation of what goes on in the real world, that there is only one place for it — and that is in the garbage can!

9 Comments »

RSS feed for comments on this post. TrackBack URI

  1. I wonder where this concept gets its validity. When a bank extends credit, the central banks increase the money supply, but the bank issuing the credit and therefore expecting the repayment plus interest must still hold in reserve a percentage of that loan in reserve as leverage. Otherwise, the bank would loan out all of its money and savings could not be withdrawn.

  2. This is of course well understood by serious economists in the finance industry.

    https://www.kreditopferhilfe.net/docs/S_and_P__Repeat_After_Me_8_14_13.pdf

    From my experience graduate economists that go on to work in the financial industry as economists are told that they will have to “unlearn” the economics they were taught when undertaking their degrees about how the monetary system works . Finance and the way it does things has its own serious problems, of course, but really this fallacy is another example of the economics profession believing that you can work without serious field work or engaging with the real world.

  3. Keynes was behind it, and its wrong. But nobody has bothered to investigate why he took this line.

  4. Why is Keynes wrong David?

  5. Henry, the short answer to you question is that Keynes failed to allow for the passage of time in his money-multiplier theory. The continuous lending of money is associated with a continuous return of it, bur Keynes failed to state that it is a different and prior loan that is being returned. By combining past and present (or present and future) returns in this way, Keynes badly claimed that a continuous amount was available for re-lending and only the reserve sum on each lending operation was held by the bank. This criterion for total sum loaned is incorrect and no multiplier of this kind exists.

    To expand on the multiplier idea, what is interesting is that money circulates around the macro-economy so it is useful to determine how much of it returns to follow the same path, and at what frequency it does this. The methodology needed to answer this question requires the use of a certain amount of logic, which Keynes and his followers seem to have chosen to ignore, but is most necessary.

    To follow-up on this please see my e-book on the theory “Consequential Macroeconomics–Rationalizing About How Our Social System works”, which I will gladly send you if you send e-message to chesterdh@hotmail.com

  6. “Keynes badly claimed that a continuous amount was available for re-lending and only the reserve sum on each lending operation was held by the bank.”

    Where did he say this?

  7. Keynes was cleaver enough to imply rather than say certain things. That is why reading his books is difficult, and if you read what someone else said about him, it is non-provable in absolute terms. What I claim about Keynes falls into this category, so I don’t have a specific answer.

  8. David,

    I am going to suggest to you that what informs your opinions are the opinions of others, namely, Von Mises and Hayek and their derivatives and I bet if you ask them to quote chapter and verse they would give a similar answer to yours – in other words this opinion is probably a fabrication.

    “To expand on the multiplier idea, what is interesting is that money circulates around the macro-economy so it is useful to determine how much of it returns to follow the same path, and at what frequency it does this.”

    To take you up on this point I thought Keynes’s multiplier was about income flows not money flows.

  9. David,

    Sorry, ignore my last comment re Keynes’s multiplier – Lars’s post is about the money multiplier.


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

Blog at WordPress.com.
Entries and comments feeds.