Monday, October 29, 2012

I get it now

What is the Money Multiplier? It is a concept, a way to understand that money is created by the banking system: A way to understand that money is created, not how it is created. Or at least it was in 1977, when I took Macro.

"Each dollar of the monetary base produces m dollars of money" - Mankiw

Since 1977, evidently, there has been a dumbing down of the concept.

Offering a Mankiw quote similar to mine, Lars P Syll opens thus:

The neoclassical textbook concept of money multiplier assumes that banks automatically expand the credit money supply to a multiple of their aggregate reserves.

Earlier today, I would have berated Syll for exaggeration. But after I found Syll's post, I went back and read Mankiw's whole chapter. Sad to say, Syll is right.

Granted, Mankiw's chapter is about Money Supply and Money Demand. Granted, his statement quoted above is only part of his exposition on the Supply of money. Granted, Mankiw says the money supply depends on three variables: the currency-deposit ratio, the reserve-deposit ratio, and the monetary base. But then he combines the two ratios into what he calls the money multiplier (m) and writes

Standing firmly on that wisp, Mankiw makes the following announcements:

•  "Each dollar of the monetary base produces m dollars of money."
•  "The money supply is proportional to the monetary base. Thus, an increase in the monetary base increases the money supply by the same percentage."
•  "The system of fractional-reserve banking creates money, because each dollar of reserves generates many dollars of demand deposits."
•  "An increase in the monetary base leads to a proportionate increase in the money supply."

In the same chapter, Mankiw considers the 28% fall of the money supply during the Great Depression, when, "in fact, the monetary base rose 18 percent". But then he goes on a tangent disguised as an explanation, and never confronts the discrepancy between his facts and his generalization.

At Syll's, the second comment (Woj's comment) makes more sense to me now.

At Woj's, Ramanan remarked

There are various levels in which people understand this

Yeah. Maybe the various levels have to do with when you learned about it. I have objected vigorously and often to the notion that because of the multiplier an increase in base money leads to an increase in the money supply. It's so obvious: You can't push on a string. Why do we need any discussion? But now I see, not everybody learned it the way I learned it. You see how Mankiw teaches the money multiplier.

The third comment at Syll's, by Pontus, expresses what I was thinking:

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.

Yeah, to my mind the multiplier did not cause increases in the quantity of money. It simply explained the process well enough that you could believe that bank loans increase the quantity of money. Explained it well enough that I could believe it, way back in 1977.

But in the years since 1977 the story changed. Mankiw says nothing about bank loans. And in the fourth comment at Syll's, Dilletaunted's reply to Pontus, we read:

I teach introductory macro, and yes, the money multiplier is presented as a causal relationship.

I would bet that Pontus learned his macro back when I did, and Dilletaunted learned it much later -- or, maybe, Dilletaunted just keeps more current.

In any event, there was most certainly a change in the way people think of the money multiplier. And it is the more recent thinking, the multiplier-as-cause thinking, that is now rejected repeatedly by Syll and Woj and Keen and many, many others. Correctly rejected.

I get it now.

// This post makes use of the Codecogs LaTeX editor

Joshua Wojnilower said...

Finally catching up on some posts as grad school is consuming most of my time. As a current PhD student I can confidently say that the multiplier is currently presented causally.

It is fascinating that it wasn't so when you learned (possibly a topic for future research). An interesting reasoning could have been the rise of monetarism around that time since it appears monetarists are most reliant on the casual version to support their theories.

The Arthurian said...

Woj I only took the one course in Macro, and I could have misunderstood, or maybe I made stuff up in my own head in the years since.

But I think the McConnell 1975 post shows that the story was different in the 1970s.

Good to hear from you, Woj. I can imagine they are keeping you busy!