Tuesday, August 17, 2010

The Money Multiplier

Much talk of late about the fiscal multiplier being less than one, so that a given amount of stimulus spending would decrease economic performance in some proportion. I think there is more to that story. But in any case, there is also the money multiplier to consider, and I've not heard much talk about that.

In monetary macroeconomics and banking, the money multiplier measures how much the money supply increases in response to a change in the monetary base.

The multiplier may vary across countries, and will also vary depending on what measures of money are considered. For example, consider M2 as a measure of the U.S. money supply, and M0 as a measure of the U.S. monetary base. If a $1 increase in M0 by the Federal Reserve causes M2 to increase by $10, then the money multiplier is 10.

Mine of July 3rd provides two graphs that suggest the money multiplier may be very small. I want to look into it more, having now read about the money multiplier. The St. Louis FRED offers this graph, which shows a sharp drop in the M1 money multiplier from about 1.6 to about 0.8 (in the fat gray bar at the right):

Before that drop, a $1 increase in the monetary base would have led to about a $1.60 increase in M1 money. After the drop, a $1 increase in the monetary base adds maybe 80 cents to M1 money. Half as much as before the drop.

For the record, the M1 money multiplier as reported by the St. Louis Fed is less than one. So the people who say fiscal policy doesn't work, the people who say the fiscal multiplier is less than one, the people who say let's depend on monetary policy instead, to those people I say... I just shake my head and shrug my shoulders.
"My guess is that scholars will ultimately decide that fiscal policy was far less important than monetary policy and measures to stabilise the banking system." -- Kenneth Rogoff in the Financial Times, 20 July 2010

Not to be ignored: the drop from a little over 3 (around 1987) to a little over 1.5 (around 2007). The multiplier fell by half in this period as well. Granted, it took twenty years. This decline was not a shocker, because it was not instantaneous. It was less disruptive and less worrisome, because it was not instantaneous. But it was an otherwise comparable decline in the multiplier.

Perhaps it was a warning. If so, it was a warning ignored.

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