The Money Multiplier Fairy Tale

Recently I discussed an ongoing debate between Simon Wren-Lewis and Lars P. Syll about mainstream versus heterodox economics. Well, there is apparently at least one topic upon which both men agree. Syll directs us to a piece from Wren-Lewis titled Kill the Money Multiplier!

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.

Last month I tried to show that IOR Killed the Money Multiplier and was directed by Ramanan to the following quote from Marc Lavioe:

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.

My first year as an economics PhD student begins in less than one month. Hopefully we skip over the money multiplier, but if not, it’s nice to know I have company in the mainstream and heterodox sects that don’t believe in this fairy tale.