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.