Home > Uncategorized > The money multiplier – neat, plausible, and utterly wrong

The money multiplier – neat, plausible, and utterly wrong

from Lars Syll

The mainstream 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.

garbageIn 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.

One may rightly wonder why on earth this pet mainstream 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!

  1. Greg Daneke
    February 6, 2023 at 4:53 pm

    Indeed! Unless that is James March’s “Garbage Can” (where it can pot out). And what about the Phillips Curve? Or most of orthodox macro (the Bankers Paradise)?

  2. rsm
    February 6, 2023 at 11:48 pm

    From the Federal Reserve’s web site:

    “As announced on March 15, 2020, the Board reduced reserve requirement ratios to zero percent effective March 26, 2020. This action eliminated reserve requirements for all depository institutions.”

    How long till they give up mucking around with interest rates, too?

  3. Gerald Holtham
    February 7, 2023 at 11:35 am

    It’s not even plausible.No practitioner believes in the money multiplier so it is fair enough to criticise text books that feature it.
    The point of reserve requirements is not to limit credit directly but to force banks to borrow additional reserves from the central bank (which will always supply them). That makes the central bank’s lending rate influential on all short-term interest rates. With reserve requirements abolished the only way the central bank can control interest rates is by paying the banks interest on their reserves. The banks won’t lend at a lower rate than they can get from the central bank. The Fed is therefore paying the banks tens of billions of dollars more whenever it raises interest rates. Pity the poor US tax payer who stumps up just to operate monetary policy since reserve requirements were abolished in deference to free market dogma and the banking lobby. That’s a bigger scandal than what some out-of-touch academic puts in a text book.

    • rsm
      February 8, 2023 at 7:44 am

      Can I tell a different story where reserve requirements were abandoned well after interest on reserves started, because the reserve requirement wasn’t effective since banks use the repo rate not the Fed Funds rate?

      And why shouldn’t the Fed implement monetary policy directly by establishing individual deposit accounts on which it pays a higher interest as inflation increases, to encourage savings?

      In other words, can the Fed’s proven powers of money creation be used to benefit individuals in addition to corporations?

  4. Gerald Holtham
    February 13, 2023 at 7:05 am

    Lending against collateral or repo comes to the same thing. The issue is whether the central bank influences interest rates via a rate used to supply finance or whether it does so by paying an unearned subsidy to commercial banks. If you are a taxpayer you will favour the former.

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