Monday, 30 July 2012

Kill the Money Multiplier!


For students, and anyone who still teaches this


Nick Rowe is exasperated at how some bloggers think all mainstream macroeconomists believe in the money multiplier and did not realise that loans can create deposits. He says go and read a first year textbook. It is true that no macroeconomist I have ever talked to about this actually thinks the money multiplier is relevant to monetary policy today. And I am sure that Nick is right that good first year textbooks tell you that loans can create deposits as well as telling us about the money multiplier. But this 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 might be that it takes time for textbooks to catch up with macroeconomic reality. But this would only be an excuse if central banks had been routinely using the money multiplier 20 or 30 years ago. It is true that there was a brief attempt to control monetary aggregates in the UK and the US in the early 1980s, but it was quickly abandoned. In the case of the UK, the money multiplier had nothing to do with how the monetary authorities tried to control monetary aggregates. So this hardly warrants inclusion in a first year macro textbook.

Another response is that there is no harm in including the money multiplier. It is a possible mechanism of monetary control, and a good intellectual exercise for students. Well, good intellectual exercises may be fine for more advanced textbooks, but they are a waste of precious time for students who may study no more macro. (I will not comment on how possible it actually is.) 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! (A more minor cost is that it can lead to debates over - as far as I can see - almost nothing of substance.)

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?

I’ve complained about this before in this blog, and in print. (In both cases I was remiss in not mentioning Brad DeLong’s textbook, which does de-emphasise the LM curve.) The comments I received were interesting. The only real defence of teaching the LM curve was that it told you what would happen if monetary policy acted in a ‘natural’ way due to ‘impersonal forces’, whereas something like the Taylor rule was about monetary policy activism. Well, I count this as an excellent reason not to teach it, because it gives the impression that there exists such a thing as a natural and impersonal monetary policy. Anyone who was around during the monetarist experiments in the early 1980s knows that fixing the money supply is hardly automatic or passive.

I know this is a bit of a hobbyhorse of mine, but I really think this matters a lot. 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.

61 comments:

  1. I too wish it would disappear, if only because I'm so fed up with reading how it proves economists are idiots whereas the writer knows how banking really works

    imho the money multiplier is taught an accounting identity not a behavioural equation, and is a perfectly good way to introduce students to the distinction between high-powered money and broader money, and to how bank lending creates money. The simple story about how a bank receives a deposit from somebody, keeps a bit back and lends the rest out, which then gets deposited somewhere else, and so on and so forth, is again imho perfectly acceptable, and it's easy to tack on the qualification "of course in reality banks don't need to have funds up front before they can lend, they can always lend first and locate funds later".

    Teaching the money multiplier does not mean teaching that central banks can increase the money supply by increasing H - when I was a TA on 1st-year Macro a few years back, an exam question asked about that and expected the answer: no, the central bank can print H all they like but if the banks don't want to lend (or perhaps borrowers don't want to borrow) the mechanism is inert, and students were expected to be able to refer to QE and what has happened to the money supply in the UK.

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    1. Luis,

      You can achieve exactly the same effect by teaching basic loan accounting and settlement, and it has the additional advantage of actually being right. The "accounting identity" to which you refer is the wrong way round in the money multiplier: deposits do not precede loans, and the double-entry accounting for a new loan does involve creating a new deposit. It is the drawdown of that deposit that requires funding, by borrowing (including new deposits) if it cannot be covered from capital. And the reserve accounting stuff isn't right either where there is no reserve requirement (as in the UK at the moment). Really the money multiplier confuses settlement of deposit drawdowns arising from lending with the creation of the loans themselves.

      I see no purpose whatsoever in continuing to teach a model of money transmission that is not only wrong in practice but actually impossible in a fractional reserve banking world. And not only continuing to teach it, but building extensive amounts of economic theory on top of it.

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    2. I don't agree. I think the double-entry accounting that goes on before loans are drawn down is not important; the story does not rest on the existence of reserve requirements; extensive amounts of economic theory are not built upon it.

      Delete
    3. n.b the accounting identity to which I refer relates M to H, and is correct. It is derived by manipulating definitions.

      Delete
    4. Louis,
      Economist take money multiplier seriously. Eg. Sumner cheers on QE that it increases the "money supply", while it only increases H which you correctly state is totally inert. Sumner criticizes Bernanke for allowing the money supply to plunge, while in the endogenous money world there is little he could do about it if people repay debt/go bankrupt instead of taking out more loans.

      So we ask for more: not only remove the money multiplier from the textbooks. Stop thinking as if it existed.

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    5. "The simple story about how a bank receives a deposit from somebody, keeps a bit back and lends the rest out, which then gets deposited somewhere else, and so on and so forth, is again imho perfectly acceptable"

      It is perfectly acceptable as an exercise in finding the limit of loans/reserves. OC, there is an easier way of finding the limit. :) If you then say that in practice, the limit is rarely approached, and also say how things actually happen, little or no harm done.

      "the money multiplier is taught an accounting identity"

      It is a limit, not an identity. Identities are unconditional.

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    6. Frances Coppola I don't think much theory is built on it, certainly not modern macro which only considers interest rates on the monetary policy side, not quantity.

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    7. Anonymous

      That's because when the Fed tried directly controlling the quantity of money in circulation it failed.

      Mind you I would equally criticise those who think that the quantity of money in circulation could (and should) be "democratically controlled" if only we would end fractional reserve banking. They know not of what they speak.

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    8. Luis,

      The accounting does matter, I'm afraid. In committed lending the double entry that goes on before the loan is drawn is what expands measures of broad money. A real deposit is created in someone's demand deposit account. That deposit is then drawn, either in cash or by some form of transfer (cheque or electronic), and spent. Funding that deposit drawdown is exactly the same as funding any other sort of deposit drawdown. It is the loan accounting itself that creates the deposit and therefore expands measures of money. Incidentally, this is not limited to regulated banks: exactly the same accounting goes on in the shadow banking system and it has the same effect.

      In the money multiplier, if the reserve drain is zero then the deposit can circulate infinitely. So reserve requirements DO matter in the money multiplier model.

      The real problem with the money multiplier is its assumption that banks are passive agents - that an increase in reserves will result in more lending. No it won't. The decision whether or not to lend is a commercial decision based on the relationship between risk and return. When banks are trying to reduce their balance sheet risk - as they are at the moment - no amount of extra money (base money increase or cheap loans) will persuade them to lend except to very good risks.

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    9. Frances,

      yes I understand the accounting, but in this context I think it's okay to skip the intermediate stage between a loan being authorised and drawn down. 1st year Macro is not an accounting class. I meant legislated reserve requirements are not important - non-zero desired reserves are. Most importantly I think it is a fundamental misunderstanding of the money multiplier to think it says banks are passive and M=mB is a mechanism central banks can always exploit. I don't know who taught you about the money multiplier (or where you read about it) but I think they taught it wrong.

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    10. Min, I don't think the money multiplier is accurate even as a limit. It doesn't correctly describe the upper limit on lending.

      The issue isn't just about recognizing that loans create deposits. It's also about recognizing that - even in a system with a reserve requirement - loans are not constrained by current reserves, either for the commercial bank individually, or for the banking system as a whole. The period in which a bank's reserve requirement is calculated, and then within which their compliance with the calculated requirement must occur, extends a few weeks beyond the time of the deposit expansion. If the expansion of deposits requires a subsequent expansion of reserves, that will happen so long as the central bank is committed to defending its policy interest rate.

      Even if a bank fails to meet its reserve requirement, the additional reserves are just credited to the bank's reserve account at a penalty rate. As I understand it, the only difference between a system with a reserve ratio requirement and no reserve ratio requirement is the threshold at which the penalty rate is imposed.

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    11. Again, this is a late comment, but in periods without a central bank -- for instance, in the Free Banking period of the 19th century US -- the money multiplier theory probably worked.

      Then, when a bank failed to meet its reserve requirement, it was shut down and liquidated!

      This causes much more conservative reserve management and means that the loan officers actually *did* call the deposit side to see if they had enough reserves (you can read about this in 19th century novels; doesn't happen any more).

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  2. I remember Greg Mankiw's text taught me money multiplier and central banks controlling money supply in undergraduate.Yes, he made it very clearly that CB's are controlling money supply not short-term term interest rate everywhere.
    Do central banks use Taylor Rule? I am not sure. For one, Benjamin Friedman at Harvard says no.

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  3. I would be able to believe all of this is I didn't see overwhelming evidence to contrary in various places, most recently the Krugman/Keen debate. Was Krugman wrong?

    It's really simple: for AD to increase, new money has to enter the economy. In our economy this must be through debt creation. Therefore, debt must accelerate for growth to increase YoY, and the level, not just the distribution, is vital for understanding growth. But no economist agrees with this.

    Here nef try to reconcile Krugman and Keen (though they do take Keen's side a bit more - unsurprisingly given that he's right):

    http://www.neweconomics.org/blog/2012/07/25/reconciling-krugman-and-keen-using-nefs-model

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    1. I'm not sure Krugman is really a macroeconomist, at least, that was never his in the literature, it was trade and economic geography, he's only a 'macroeconomist' in the NYT.

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  4. If the money multiplier is gone then the CB doesn't control the credit creation and we get exploding debt episodes line this: http://www.angrybearblog.com/2011/12/its-private-debt-stupid.html

    Which means that the whole equilibrium framework of mainstream economics goes out the window.

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    1. Exactly. I wrote a post today on reducing the debt-per-dollar ratio that includes several graphs of credit market debt compared with the monetary base (http://bubblesandbusts.blogspot.com/2012/07/reducing-debt-per-dollar-ratio-long.html). This is why many people, including myself, favor fiscal policy over monetary policy given the exploding debt of the past 30 years or so.

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  5. Simon: very good question.

    My answer(s):

    1. Canada has no required reserve ratios today. But ECON1000 is not just about Canada today. E.g. Canada had required reserve ratios in the past. E.g. China has required reserve ratios today (many of my students are from China, and China is a big country even non-Chinese students need to know about).

    2. The reserve ratios in the MM model are NOT (should not be interpreted as) *required* reserve ratios. They should be interpreted as *desired* reserve ratios (including cash balances held at banks). And "excess" reserves should be interpreted as actual minus *desired*, not required, reserves.

    3. The part of the MM story that matters, and that tells us something important, is *not* the comparative statics equilibrium result. dM=(i/rr)dB is pretty useless. But the disequilibrium process story is what's important. Can/might that disequilibrium process story go on for an infinite number of multiple rounds, never converging? Yes! Unless the central bank stops it, and the central bank will need to stop it. And that is telling us something important about Wicksell and the hot potato and the (absence of) self-equilibrating properties of a monetary economy under interest rate control.

    It's that third and last point that is most important, in my view. Throw away dM=(1/rr)dB if you like, but keep the disequilibrium process story!

    But first year textbook writers face one additional problem (and not just structural innate conservatism of the market). We need a theory of the AD curve that works for the long run as well as for the short run. Because we want to keep it simple, and don't want two different AD curves. And if you have a vertical LRAS curve you need a downward-sloping AD curve for the long run. But if monetary policy is seen as fixing a rate of interest, you get a vertical AD curve. If instead monetary policy is seen as fixing M, you get a downward-sloping AD curve, which works nicely for both long and short runs. (And if monetary policy is seen as fixing the rate of inflation, which is what it does in fact do, in modern monetary theory for modern countries, you get a horizontal long run AD curve, which doesn't work well in the short run).

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    1. Nick

      Even though (1) and (2) are good points, they still do not warrant a place in first year macro because this control mechanism is not used, and has not been used, in the UK or US. I must admit I do not know, and probably should know, about China.

      I need to think about hot potatoes, but surely its simple to get at instability with constant nominal rates for first year students by just thinking about the IS curve and a naive inflation expectation process.

      I agree about what you say about the AD curve, but I would also want to throw away the AS/AD curves. I can do all the macro I want with a Phillips curve rather than an AS curve. So I would just teach first year students about the Phillips curve and the IS curve, and throw away MM,LM,AD,AS and Mundell Fleming. In other words I would teach something very similar to the 3 eqn model in Carlin and Soskice.

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    2. Simon: OK. But there's something strange when:

      In micro, we put P on the vertical axis of supply and demand curves.

      In macro, we put the rate of change of P on the vertical axis of supply and demand curves.

      "The fetish of the first derivative"!

      "We have advanced one derivative since Hume"!

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    3. Simon,

      if you go straight to 3-equation baby DSGE, and ditch teaching the money multiplier, when would the main body of students learn about the difference between base money and broad money, and about money creation via credit expansion?

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    4. Even when Canada had reserve requirements, I don't think banks were often fully loaned out, but the rate of excess reserves was stable enough that in normal times it could be treated as a constant. One advantage to teaching about the money multiplier is that it lets you get banks' objectives into the model - their willingness to make loans. That comes through very clearly in the current numbers, and helps when you want to explain the problems you can run into trying to use the monetary base as an expansionary tool.

      I have a feeling China has been using reserve requirements as a policy tool - I think I saw something about them tightening up not too long ago.

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  6. This comment has been removed by a blog administrator.

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  7. There are a few things here I don't get.

    First, the money multiplier is a relation. It doesn't say anything about causality. Second, who said that the multiplier is constant? Third, while loans do create there own deposits, these do not come without cost. Banks must, on an everyday basis, engage in the federal funds market to get their reserves right (either by mandate, or for precautionary reasons). This cost money. If the fed funds rate is high, banks might think twice before they expand on the loan side. And if it's low, they might get more lavish (but not always). But all in all, the total amount of loans will be a multiplier of a bank's reserves.

    To me all of this basically means that the CB can limit expansions in credit to an arbitrary extent by adjust reserves. But they cannot limit contractions (for ZLB reasons).

    I think the point of the MM is that there are a helluva lot more money out there than the coins and bills in circulation. And this is an important message.

    First, of course loans can create there own deposits! Claiming that's a heterodox idea is absurd. But banks cannot expand their balance sheets without costs.

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    1. "First, the money multiplier is a relation. It doesn't say anything about causality."

      Yes it does:

      "Models of the money supply multiplier link the
      money supply to the monetary base in a relationship
      of the following form:

      M - mB

      where M# the money supply;
      m # the money supply multiplier;
      B # the monetary base.
      In models such as this, m tells us how many times the
      money supply will rise following an increase in the
      monetary base."

      "Second, who said that the multiplier is constant?"

      Nobody in while.

      "Third, while loans do create there own deposits, these do not come without cost."

      Correct. Nobody ever claimed that there is no cost to lending money.

      I'm sorry but you guys need to stop telling everyone they don't understand economics and understand it yourself. If endogenous money is true (which you claim it is) then Keen's model is also correct and private debt drives AD, directly, not through distribution but through the level.

      The fact is that you can't accept endogenous money fully because it collapses half of your macroeconomic models. You can pretend you do when asked about the specific issue but return to it in your models.

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    2. I can't think of any macro models it really changes, since how money is increased is exogenous to most models (or can be made such, the IS-LM model can be reformulated without a money multiplier), it is not embedded in the model itself (deliberately, given that monetary institutions may change over time). It might render some models less useful, since they can't predict the path of exogenous money/credit expansion (though some can!), that doesn't make them wrong, just limited.

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    3. Oh my god. I'm not really sure to begin.

      First, "endogenous" money does not in any way imply that "keen's model is correct". If you don't understand why this is so, I don't think there is any need for further discussions.

      Second, if you look at a standard textbook, say Woodford's Interest and Prices, you'll see that it's all about endogenous money. The economy creates whatever money it needs to keep the wheels spinning, but always and everywhere subject to the costs set by the fed. Money IS endogenous. But from that it doesn't follow that debt "drives" AD.

      Why don't you tell me how, for instance, Woodford's 2003 paper with Eggertsson abstracts from endogenous money creation? Let's take it from there.

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    4. ue

      "m tells us how many times the money supply will rise following an increase in the monetary base."

      is that a quote from a text book? Which one? It's not how I was taught it. Consider profit=margin*revenue. That does not tell us how much profits will rise if revenues do, because we don't know what happens to prices and costs: margin is not a constant. Similarly we know m is not a constant (just look at the data) and similarly M=mB is not a causal relationship but an accounting identity (look at how it is derived from identities in the Blanchard text for example).

      Now it might be that in "normal times" it makes sense to regard m as reasonably stable, but as I said above, if you'd written "m tells us how many times the money supply will rise following an increase in the monetary base" in our first-year exam, you'd have dropped lots of marks.

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    5. @pontus

      "First, "endogenous" money does not in any way imply that "keen's model is correct". If you don't understand why this is so, I don't think there is any need for further discussions."

      It implies that debt created ADDS to purchasing power. You CANNOT say that you accept endogenous money without accepting this implication.

      I don't know about every single textbook. But economists should try and make theirs more consistent, because mine says nothing of the sort.

      "Why don't you tell me how, for instance, Woodford's 2003 paper with Eggertsson abstracts from endogenous money creation? Let's take it from there."

      I assume you mean optimal monetary policy in a liquidity trap?

      http://www.columbia.edu/~mw2230/Japan.pdf

      They argue (simplifying slightly) increases in MB will have no effect at the ZLB. This is compatible with both frameworks and it doesn't really get us anywhere.

      @luis

      "is that a quote from a text book? Which one?"

      Applied economics, Alan Griffiths.

      "if you'd written "m tells us how many times the money supply will rise following an increase in the monetary base" in our first-year exam, you'd have dropped lots of marks."

      Great - no true scotsman.

      @anon

      "I can't think of any macro models it really changes, since how money is increased is exogenous to most models (or can be made such, the IS-LM model can be reformulated without a money multiplier), it is not embedded in the model itself (deliberately, given that monetary institutions may change over time)."

      So it changes them. Because money should be endogenous to the model.

      Guys: take an actual position. Do you accept endogenous money a la Minsky/Keen, or not? If so, why so dismissive of the models? If not, well, why so dismissive of the models when they clearly model crises like the current one?

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    6. Unlearningecon, I would absolutely love to see more models with endogenous money, I don't know anyone who would be against the idea. There were already a number of models tried in the literature, but they came up against computational problems. Apparently Keen has overcome these problems, I think his models would have been prominent in the literature by now with much progress being made if he didn't try to smear and marginalise his colleagues instead of engage them in good faith - the absolute worst approach he could have taken (unless, you know, he wanted to seek attention and fame).

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    7. I'm pretty sure economics has a rigid academic hierarchy and Keen has tried to get his papers submitted. The problem is that once you depart too much from the conventional story the papers get blocked. Keen's work isn't microfounded in preference driven individuals, so it didn't make the cut.

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    8. "no true Scotsman"

      oh Lord well I suppose that for all I know most other universities taught and economists believe that M=mB is a straightforward causal mechanism with constant m, and what I had hitherto thought was my perfectly mainstream economics education at mainstream universities was the exception not the rule. If so, so much the worse for economics.

      I'd have thought it quite obvious that m ain't necessarily a constant and particularly in times such as these loans may stay unmoved whilst the reserve fraction rises. And maybe my mainstream experience is representative.

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    9. Ok, last reply. I don't want to pester Simon's blog anymore with this nonsense.

      @ Unlearningecon. Here's how monetary policy normally works: If the central bank wishes to expand money supply, it conducts open market operations in the federal funds market. Normally by purchasing short term government debt. In exchange, it pays wish reserve money. Now, banks tend to use this money and lend it out (=debt). The debt will trickle through the economy and create more debt in a money multiplier fashion (you seriously don't believe that the total amount of money will widely exceed the additional reserves?). In the end we'll see a rise in demand and a rise in output (and eventually inflation).

      But that's monetary policy! The ideas are 200 years old. What does that have to do with Keen!? Expansionary monetary policy generates a lot of debt, and expansionary monetary policy have ... eh ... expansionary effects on economic aggregates. This is all old news.

      But this is not *debt* creating demand. It's money. If Keen, or you for that sake, want to claim that debt per se creates demand, you will have to isolate debt in the absence of money. For instance, if I don't buy that TV, but lend out the money to my neighbour (=debt), and he buys the TV, will that increase demand? No, it's a wash. So please explain to me how one person's non-spending which leads to another person's spending increases aggregate demand.

      I think you should change the name of your blog to "neverreallylearnteconomics"

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    10. pontus, everything you just wrote conflicts directly with your prior statement that "The economy creates whatever money it needs to keep the wheels spinning, but always and everywhere subject to the costs set by the fed."

      So which is it? Does the Fed decide the interest rate floor at which banks lend and accommodate whatever money demand might be at that rate, or does the Fed set the money supply and let the interest rate fall where it may?

      Can the Fed expand lending by expanding the money supply, as your immediately prior comment argues, or can it only reduce the contraction it imposes on lending by easing its constriction of the money supply? This is an important operational distinction, which the money multiplier story obscures.

      "For instance, if I don't buy that TV, but lend out the money to my neighbour (=debt), and he buys the TV, will that increase demand?"

      Loanable funds fallacy.

      In a modern economy your neighbor would borrow from a bank. Since the bank can always lend to your neighbor if it wants to (even with no deposits, because it can simply borrow from the central bank at the policy rate plus some minor spread), there is no causal relationship between your decision to not-buy the TV and your neighbor's ability to buy the TV.

      "But, but, but," you object, "the TV is a rival good - somebody has to produce it." Well, yes, but since money is not a veil over barter it does not follow from the fact that TVs are rival goods that the loanable funds fallacy is applicable to the example.

      - Jake

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    11. pontus -

      Yep, that's loanable funds theory. You don't use endogenous money theory.

      That's all I wanted to establish ;)

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    12. It's only nonsense because you make it so. At least now we know that when you assert you have incorporated endogenous criticisms you are wrong/lying.

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    13. "I think you should change the name of your blog to "neverreallylearnteconomics""

      Nope, I learned the theory you describe, then realised that the evidence doesn't corroborate with it. You, on the other hands, are ignorant of this fact yet continue to act condescending.

      Typical mainstream economist. Nothing new to see here, keep clinging to your models despite their abject failure to foresee and deal with the crisis.

      Sorry for triple post.

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    14. @Jake, no there is no conflict whatsoever with what I've previously said. The fed does not control money supply, it controls reserves. It can expand or contract reserves with virtually unlimited discretion, but how these reserves will trickle through the economy is beyond the central bank's control.

      My statement is simple: By engaging in open market operations, the fed can expand reserves. In normal times (positive nominal interest rate), these reserves will trickle through the economy and there will be more money created (endogenously!) than the reserve amount. This is called the money multiplier.

      And I have no idea what you're talking about when it comes to the example of the TV. Do you seriously not think that banks engage in intermediation? Well, fyi, it does. And if you want to claim that *debt* raises AD, you must show that a simple rise in intermediation raises AD. Otherwise your talking about monetary policy, and are just dressing up a decade old idea in new clothes, calling it "heterodox".

      unlearningecon - So that's not how monetary policy works? The central bank CANNOT purchase short term t-bills in the federal funds market? The central bank cannot pay with reserves? Reserves will not under normal times translate into debt? And debt will not multiply into more debt?

      Why don't you explain what is wrong here, and why? Let me guess: Because you can't.

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    15. To avoid clogging up Simon's blog, here's a comment as a google doc

      Alarmed by the prospect that I might be the only economist not to regard M=mB as a causal mechanism, I looked up this Griffith book (not one I'd heard of). After the excerpt Unlearning Economics quotes it goes on to say:

      "But what determines the value of m? In fact, there are two factors: the decisions of depositors about their holdings of currency and deposits, and the level of reserves the banks hold to meet customer demands for currency.... Whether the money supply multiplier is an adequate explanation of the money supply process depends partly on the stability of the ratios c and r [reserve ratio]...Certainly for the UK the general view is that the money supply multiplier is unstable in the short run"

      So the text book does not say M=mB is a causal mechanism with stable m - if r increases, B can increase and M will not.

      Unlearning Economics, I'm not impressed by your selective use of quotation.

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    16. perhaps I should have said, it's a comment on the endogenous/exogenous money thing

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    17. if anybody is interested, I also looked at the Blanchard text, which is the one we use, and it's discussion of the multiplier does not emphasize that the reserve ratio may change in such a way that increasing B will not increase M, although it's plain that would be the case. Mankiw's text does talk about banks holding excess reserves and says the money supply sometimes moves in ways the Fed does not intend.

      So Nick Rowe's exhortation to all those who think economists don't understand money creation - read a first-year text book - looks justified.

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    18. Luis, that does not alter it at all and is not selective. I know they go on to assert that it is not stable. It doesn't change that they teach the fundamental money multiplier relationship. Endogenous money rejects this completely, stable or not. Monetary policy is not simply about the 'demand and supply' for base money.

      pontus, you should really stop making overarching statements that I assume I do not know what I am talking about. We've already established you do not understand the difference between endogenous money and the money multiplier, now I realise that you cannot even comprehend that there could be an alternative theory.

      The money multiplier teaches a causal relationship that goes like this:

      M0 > M1+

      So what does evidence suggest?

      "There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly."

      From the father of RBC,no less: http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=225

      This is not the money multiplier story - I am sure you will find a way to explain why reality is wrong, but whatever.

      The fact is that, in the real world, banks extend loans to people and credit their accounts with a deposit simultaneously. The result is extra purchasing power. The banks don't need deposits to 'lend out' (although capital base matters). In the short term they get reserves when they need them but the CB can exert long term influence via setting the rate.

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    19. UE

      Get a grip.

      Above I claimed mainstream economics does not just teach "if B goes up M will go up" and you accused me of the one true Scotsman fallacy. You cited a textbook supposedly demonstrating economists teach M=mB as a causal mechanism, but I showed that same text book does no such thing because it goes on to say m is not stable. As I predicted elsewhere, you just respond with bluster instead when an apology would be more in order.

      One last try: profits=margin*revenue is not a casual relationship showing if revenues increase profits will increase because margin is not stable. It is an accounting relationship. M=mB is not a casual relationship showing if B increases M will increase because m is not stable. It is an accounting relationship. If you cannot understand this, I suggest you retire from your current career as the scourge of economics.

      Right now we have had a massive increase in B but not M because m has collapsed because reserve ratios have rocketed - that is what the bloody money multiplier captures.

      Delete
    20. Oh good god.

      You are still not grasping that the textbook still supposes that, in order to increase M, B must first be increased. That m is not stable does not changed this.

      I outlined why this is wrong in my response above.

      Delete
    21. "The fed does not control money supply, it controls reserves."

      Not when it wishes to defend an interest rate target. Which is always. Unless it pays a support rate on excess reserves and consistently maintains sufficient reserves in the system that no bank ever finds itself short of reserves.

      In other words, only when reserves are of no economic interest whatever.

      "It can expand or contract reserves with virtually unlimited discretion,"

      Not when it wishes to defend an interest rate target. Which is always.

      "but how these reserves will trickle through the economy is beyond the central bank's control."

      Now you're boarding the loanable funds crazy train. Reserves don't "trickle through the economy." They are created and destroyed at need.

      "My statement is simple: By engaging in open market operations, the fed can expand reserves. In normal times (positive nominal interest rate), these reserves will trickle through the economy and there will be more money created (endogenously!) than the reserve amount. This is called the money multiplier."

      This is false. The Fed can only create reserves after banks have already decided to extend loans. Otherwise, the interbank rate would crash clear down to the support rate.

      The bank decides to make the loan based on the CB's policy rate. No banker has ever checked the monetary aggregates before deciding whether to grant a loan application or not, and it is simply silly to suppose that any ever will.

      "And I have no idea what you're talking about when it comes to the example of the TV. Do you seriously not think that banks engage in intermediation? Well, fyi, it does."

      Nothing prevents a bank from lending without ever having a single deposit.

      To call this "intermediation" places a greater burden on the logic and semantic resources of the English language than it can reasonably be expected to bear.

      "And if you want to claim that *debt* raises AD, you must show that a simple rise in intermediation raises AD."

      Again, "debt is intermediation" is the loanable funds fallacy. Debt it is the creation of purchasing power out of thin air - no input of purchasing power is required at all, so there is nothing to "intermediate."

      This really shouldn't be controversial. It's not even Minsky or Keynes, it's fucking Schumpeter. If you don't understand this, then you haven't been paying attention at any point in the last one hundred years.

      "The central bank CANNOT purchase short term t-bills in the federal funds market?"

      It can.

      "The central bank cannot pay with reserves?"

      It can.

      "Reserves will not under normal times translate into debt?"

      Reserves will not translate into debt. An increase of debt forces the central bank to create more reserves. Once the central bank has decided upon an interest rate target and a set of margin requirements, it has no further discretionary power over the level of lending, or circulating reserves. Reserves are simply irrelevant to the story.

      "And debt will not multiply into more debt?"

      No. Debt is created and destroyed at need. Existing debt or money is not a prerequisite for the creation of debt.

      This has been another edition of "simple answers to simple questions."

      - Jake

      Delete
    22. Fail. M=mB means B could decrease and if m increased sufficiently then M would increase. If m is not stable, m may increase. So the textbook does not suppose that B must first be increased to increase M.

      Delete
    23. Enrique: Please direct your efforts towards educating people like pontus who labor under the loanable funds delusion, before you complain about people who criticize neoclassical economics for misleading people about the nature of credit and its economic significance.

      If your textbooks have given pontus the impression that loanable funds are correct and banks are merely intermediaries, then it doesn't matter what the textbooks say. What matters is what people who read them take away from the process.

      Because Murphey's Law applies to textbooks too: If a reader can come to a right and a wrong conclusion based on the textbook then, no matter how unkind a reading the wrong conclusion would be, then the textbook is fatally and fundamentally flawed as an educational device.

      - Jake

      Delete
    24. Jake,

      I don't know, I think you make some good points but you are overdoing it - I have my quibbles with your response to Pontus above. Would be interested to read your response to my comment on separate doc above, at comment dated 02:44. Move to email I think so as not to pollute this space.

      Delete
    25. "Fail. M=mB means B could decrease and if m increased sufficiently then M would increase. If m is not stable, m may increase. So the textbook does not suppose that B must first be increased to increase M."

      Fair enough. How's this:

      'there must be enough B for M to increase past a certain point, depending on B.'

      Also, when will you just admit that economics does not teach endogenous money?

      Delete
  8. Simon,

    Good post. I posted a link on my site (http://bubblesandbusts.blogspot.com/2012/07/the-money-multiplier-fairy-tale.html) and added the following quote from Marc Lavoie, as it relates to current discussion about IOER:
    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.

    ReplyDelete
  9. The idea of the money multiplier is accepted by all schools of economics which is why it is found in textbooks by Keynesians and Austrians and monetarists. This is rather surprising because neither Keynes nor Mises had any use for it.

    In a recent paper I have shown why the idea of the multiplier is wholly incorrect. http://www.philipji.com/the-money-multiplier.pdf

    The error is, however, key to the confusion about money in modern macroeconomics, whether Keynesian or Austrian which is why my book "The General Theory of Money" begins with it. http://www.amazon.com/dp/B0080WPK2I

    ReplyDelete
  10. the money multiplier is applicable in fixed fx regimes, where banking is necessarily reserve constrained, but inapplicable in today's floating fx regimes where banking is not reserve constrained.

    See more at www.moslereconomics.com beginning with 'soft currency economics (1994) under 'mandatory readings'

    Warren Mosler
    MMT First Generation

    ReplyDelete
    Replies
    1. I disagree. Attempting to impose a currency peg does not give you a reserve-constrained credit system.

      It gives you a deeply dysfunctional solvency-constrained credit system. Because in practise credit will not be cut off (indeed cannot be cut off without creating a severe industrial depression) merely to accommodate a specie requirement. Reserve requirements will be massaged sufficiently instead (which was indeed what historically happened under the gold standard).

      The real impact of a specie peg is that it enables a run on the sovereign. It doesn't even give the sovereign a proper intertemporal budget constraint, because even adhering strictly to a self-imposed intertemporal budget constraint will not protect the government from a run on the currency (for the same reason that merely being solvent will not protect a bank from a run on its deposits).

      - Jake

      P.S.: The top-level comment timestamped 30 July 2012 12:32 is spam.

      Delete
    2. "the money multiplier is applicable in fixed fx regimes"

      Completely incorrect.

      Delete
    3. "the money multiplier is applicable in fixed fx regimes"

      Completely incorrect.

      Ditto

      Delete
  11. What intermediate undergrad and PhD macro texts do you like?

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  12. First of all I am not in the level of most people here, so please, correct me if I am wrong. Second I am trying to condensate a relatively complex idea in a few lines, please be nice to me .....

    I think that perhaps we can find a good reason for studying banking multipliers: the money offer becomes quasi-exogenous so that interest rates becomes a mere reference to the markets intead of being stone written trues.

    The thing is that the meaning of this seems to be particularly troublesome. If we consider the existence of a basic interest rate in the market that is considered as risk free, and at the same time we consider that this rate also represents government's capacity to pay for its debt once it represents this debt intertemporal cost, we will fastly conclude that government economic policy is about continualy inflating and deflating the same economic bubble. I know it sounds too strong, but I would need much more space in order to write down the whole idea.

    I will try to summarize it: there is in the idea of economic cicles the concept of expansion and recession. Recession is the time for government to do counter ciclical economic policy and expansion is the time for austeriry.

    The problem is that in a political society it is hard to take austerity measures due their impopularity while at the same time accumulating debt increases the cost of debt and financial instability.

    In the other hand when the time to cut budgetary expenses comes, what tends to be cutted are the non-essencial expenses - or in other words: social wellfare expenses.

    The thing is that this political reality leaves scars that could mean the shortening of the wellfare state or the accumulation of debt - and in the long run both of them.

    Which means that society is less prepared to the effect of recessions as an effect of the previous periods recessions. The Washington Consensus and Giddens Minimum State are examples of this. Paralel to this, the grouth of the servieces sector means a higher volatility due the instable character of the terciary sector.

    The consequence of the sum of all these factors are irrational exuberance and the Washington Consensus are one side of the coin and the ni-ni generation all over the world are in the other. Both sides reflecting different the same coin, or in toher words society's development.

    How did I concluded this? By understanding the macro aggregates during my first courses in Macro. I believe the multipier itself is not so important, but the idea of quasi-exogenity of the monetery aggregates should lie at the base of a any macro analisis and therefore should be studied from the very begining

    Did I got everything wrong?

    ReplyDelete
  13. Hello, Prof. Simon.
    I'm an amature economist in Japan.
    I translated this article into japanese, please tell me if you don't like such translation.

    ReplyDelete
  14. This is a very late comment, but...

    The Money Multiplier theory appears to have been a tolerably good description of the broad money / base money behavior under a Free Banking system, with a gold standard, during a boom. These are, of course, the conditions under which the theory was developed!

    It has nothing to do with modern economies.

    A historical treatment of economics, focusing on changes in institutional structure and economic regime, might well want to include the money multiplier.

    As far as I know (correct me if I'm wrong) the money multiplier still works as a description of a free banking / required reserves / gold standard regulatory regime, where gold is the monetary base, required reserves must be made of gold, the bank-created money supply is limited by the legal ability of the licensed banks to create additional money due to the reserve ratio, and the reserve holdings of the banks are regularly audited.

    One little change in this policy -- allowing interbank loans to qualify as reserves without physical transfers of gold, or creating a Federal Reserve Bank -- causes the money multiplier theory to stop applying.

    The money supply is driven very much by regulatory, institutional considerations. The money multiplier is an artifact of a former institutional regime. Is it worth teaching? Perhaps it is, in order to remind your students that the correct macro analysis depends entirely on legal, regulatory, and institutional structure considerations. But it's not relevant to *today's* institutions.

    ReplyDelete
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