The Money Multiplier Doesn't Exist

The Myth Of The Money Multiplier by Barkley Rosser @ EconoSpeak

That Fed control over the money supply has become a phantom has been quite clear since the Minsky moment in 2008, with the Fed massively expanding its balance sheet without much resulting increase in measured money supply.  This of course has made a hash of all the people ranting about the Fed "printing money," which presumably will lead to hyperinflation any minute (eeek!).  But the deeper story that some of us were unaware of is that apparently this disjuncture happened a long time ago.  Even so, one of our number pointed out that official Fed literature and even many Fed employees still sell the reserve base story tied to a money multiplier to the public, just as one continues to find it in the textbooks,  But apparently most of them know better, and the money multiplier became a myth a long time ago.

Woj’s Thoughts - Rosser refers to a paper from the Federal Reserve Board’s Finance and Economics Discussion Series that was the source of a recent Quote of the Week:
“Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?” (by Seth B. Carpenter and Selva Demiralp, May 2010):

Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected.

As I noted in that post:

If staff members at the Federal Reserve are aware of the money multiplier myth than surely Bernanke and the other board members have heard the arguments. Unfortunately most mainstream economists, especially monetarists, continue to promote monetary stimulus as if the old regime still persists.

Fortunately the economics professors at James Madison stumbled across this paper and were convinced of its conclusion. Hopefully they will join a minority of current economists in training future economists to recognize the money multiplier does not exist.

Related posts:
Fullwiler - "The main shortcoming of the money multiplier paradigm"
IOR Killed the Money Multiplier
Fighting for Endogenous Money on Two Fronts

The Impossible Trinity or The Permanent Floor: Adding Modern Money to Mundell-Fleming

The Impossible Trinity (also known as the Trilemma) is a trilemma in international economics which states that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. This principle was initially derived from the Mundell-Fleming model, also known as the IS-LM-BoP model. Although the model was first outlined by Mundell and Fleming 50 years ago, to this day it continues to play a significant role informing public policy. For this reason it also remains a staple of Ph.D. programs, even those that generally despise Keynesian economics.

While many students may accept the model’s conclusions based on its longevity and the professions’ widespread adherence (which may be wise), I was naturally skeptical. What are the model’s assumptions? Will different monetary regimes alter the conclusions? What does it even mean to have “an independent monetary policy”? In search of answers, I sought out one of the original sources.

“Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates” by R.A. Mundell was published in The Canadian Journal of Economics and Political Science all the way back in November 1963. At the time the world’s major industrial nations were adhering to the Bretton Woods system, under which the U.S. dollar was convertible to gold and all other countries involved tied their currencies to the U.S. dollar. Recognizing the expansion of global trade taking place, Mundell sought to outline “the theoretical and practical implications of the increased mobility of capital. (p.475)” To simplify the conclusions Mundell begins by assuming “the extreme degree of mobility that prevails when a country cannot maintain an interest rate different from the general level prevailing abroad. (p.475)” He further assumes “that all securities in the system are perfect substitutes” and therefore the “existing exchange rates are expected to persist indefinitely. (p.475)” The last assumption presently worth noting is that “Monetary policy will be assumed to take the form of open market purchases of securities. (p.476)”

While these assumptions may have been valid within the Bretton Woods system, that system was terminated in 1971 by President Nixon unilaterally canceling the direct convertibility of the U.S. dollar to gold. Since then the U.S. and several other major industrial nations have been operating using a fiat currency. Under this new monetary regime, without convertibility, there is little reason to believe that all currencies are even near perfect substitutes or that exchange rates will persist for any defined period of time. Furthermore the end of the Bretton Woods system marked the beginning of inflation targeting as the primary method of monetary policy.

Monetary policy was still enacted through open market operations after the regime change, but those operations were now performed to maintain an target interest rate. The more significant difference is that using interest rates as the primary tool for targeting inflation ensured interest rates would be maintained at levels different from those prevailing abroad. This “corridor” system of inflation targeting would last in the U.S. for nearly 40 years before being replaced by a “permanent floor” system in 2008.

Breaking with previous tradition, the “permanent floor” system (also known as interest-on-reserves regime) allows central banks to control interest rates separate from engaging in open market operations. Interest rates are now (largely) determined by the interest-on-reserves (IOR) rate, while excess reserves give the central bank freedom to let the monetary base fluctuate more widely.  

Returning to Mundell’s paper, he begins by analyzing monetary policy under flexible exchange rates:

“Consider the effect of an open market purchase of domestic securities in the context of a flexible exchange rate system. This results in an increase in bank reserves, a multiple expansion of money and credit, and downward pressure on the rate of interest. But the interest rate is prevented from falling by an outflow of capital, which causes a deficit in the balance of payments, and a depreciation of the exchange rate. In turn, the exchange rate depreciation (normally) improves the balance of trade and stimulates, by the multiplier process, income and employment. A new equilibrium is established when income has risen sufficiently to induce the domestic community to hold the increased stock of money created by the banking system. Since interest rates are unaltered this means that income must rise in proportion to the increase in the money supply, the factor of proportionality being the given ratio of income and money (income velocity). (p.477)”

The earlier review of changes to the monetary regime makes it clear that this causal chain is fraught with errors. Starting from the beginning, “an increase in bank reserves” does not cause “a multiple expansion of money and credit” (see here) nor will it lead to “downward pressure on the rate of interest.” If interest rates are unchanged, there should be no outflow of capital and no subsequent depreciation of the exchange rate. The balance of trade therefore remains the same and the “multiplier process” never takes place. In complete contrast to Mundell’s conclusion, monetary policy (effectively QE) has no effect on income or employment under flexible exchange rates.*

Switching to monetary policy under fixed exchange rates:

“A central bank purchase of securities creates excess reserves and puts downward pressure on the interest rate. But a fall in the interest rate is prevented by a capital outflow, and this worsens the balance of payments. To prevent the exchange rate from falling the central bank intervenes in the market, selling foreign exchange and buying domestic money. The process continues until the accumulated foreign exchange deficit is equal to the open market purchase and the money supply is restored to its original level. (p. 479)”

As previously stated, the creation of excess reserves no longer affects the interest rate. This prevents the rest of Mundell’s process from taking place, but nonetheless results in the conclusion that monetary policy is ineffective.

This fixed exchange rate simulation serves as the basis for the Impossible trinity. Given free capital flows and a fixed exchange rate, the central bank is forced to counteract open market operations with equivalent opposing actions in the foreign exchange market. Since the money supply is ultimately unchanged, the country is said to have relinquished its monetary policy independence. However, under the current monetary policy regime this outcome is drastically altered.

Mundell examines the common case of a country trying “to prevent the exchange rate from falling. (p. 479)” Using a “permanent floor” system the central bank can maintain its interest rate policy and a fixed exchange rate, but faces limitations since “the central bank intervenes in the market, selling foreign exchange and buying domestic money. (p. 479)” One limitation arises when the central bank runs out of salable foreign exchange. Another limitation occurs once the central bank drains all excess reserves from the system, forcing it to forgo either its interest rate or exchange rate policy. These limitations suggest the Impossible Trinity will hold in the long run.

Now consider the less frequent and more recent case of a country trying to prevent its exchange rate from rising. The central bank manipulates the market exchange rate by buying foreign exchange and selling domestic currency. Contrary to the previous example, the central banks actions suddenly appear unlimited. Since the central bank can always create new reserves, it faces no limitations in selling domestic currency. Meanwhile if the demand to trade foreign exchange for domestic currency dries up, then the central bank will have successfully defended its peg. Therefore, as long as the Fed is willing to accept the risks associated with a balance sheet full of foreign exchange, the Impossible trinity is no longer impossible.

The Impossible trinity stems from Mundell and Fleming’s attempt to incorporate an open economy into the IS-LM model. Their analysis reflects an understanding of the Bretton Woods system, which ruled monetary policy at that time. Today’s monetary system and policy operations are a far cry from the Bretton Woods system, yet the Mundell-Fleming model has not been updated accordingly. Beyond minimizing the effects of monetary policy, the transformation of monetary policy to a “permanent floor” system has made the previously impossible, possible.



*In reality, monetary policy (QE) will affect income and employment to some degree for reasons not outlined by Mundell. However, those effects are likely to be small and could be either positive or negative.

Related posts:
Does the Permanent Floor Affect the Inflationary Effects of the Platinum Coin?
The Permanent Floor and Potential Federal Reserve 'Insolvency'
Fed's Treasury Purchases Now About Asset Prices, Not Interest Rates
The Money Multiplier Fairy Tale
Currency Intervention and the Myth of the Fundamental Trilemma
IOR Killed the Money Multiplier
Despite Hicks' Denouncing His IS-LM Creation, The Classroom Gadget Lives On

Bibliography
Mundell, R. A. "Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates." The Canadian Journal of Economics and Political Science 29.4 (1963): 475-85. Print.

Quote of the Week...

…is from the Federal Reserve Board’s Finance and Economics Discussion Series paper, “Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?” (by Seth B. Carpenter and Selva Demiralp, May 2010):

Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected.

If staff members at the Federal Reserve are aware of the money multiplier myth than surely Bernanke and the other board members have heard the arguments. Unfortunately most mainstream economists, especially monetarists, continue to promote monetary stimulus as if the old regime still persists.  

Related posts:
Fullwiler - "The main shortcoming of the money multiplier paradigm"
IOR Killed the Money Multiplier
Fighting for Endogenous Money on Two Fronts

Are Fiscal and Monetary Policy Both Ineffective?

Tyler Cowen asks us to ponder the following sentences:

This first figure shows that aggregate demand growth has not been affected by a tightening of fiscal policy since 2010.  Specifically, it shows that nominal GDP (NGDP) growth has been remarkably stable since about mid-2010 despite a contraction in federal government expenditures.

Those sentences are from prominent Market Monetarist and NGDP Targeting proponent David Beckworth. His conclusion based on the above graph and a similar one depicting the declining budget deficit is that:

Both figures seriously undermine the argument for coutercyclical fiscal policy and suggest a very a low fiscal multiplier.  They also indicate that the Fed has been doing a remarkable job keeping NGDP growth stable around 4.5%. Monetary policy, in other words, appears to be dominating fiscal policy in terms of stabilizing aggregate demand growth.

Trying to find support for Beckworth’s claim, I thought a brief look at how changes in the money supply over the past couple years compare with NGDP might do the trick. Here’s what I found:
The above chart shows that NGDP has been largely unaffected by both severe tightening and expansion of monetary policy since 2010. Looking at M2 versus NGDP growth displays a similar story:
Both charts suggest that changes in the money supply have little impact on NGDP growth. Given that percent changes in either money supply measure are far greater than those of recent fiscal policy, one might conclude that monetary policy has a smaller multiplier than fiscal policy.

Based on the above charts, which conclusion should we accept? Or are both fiscal and monetary policy ineffective? The reality is that all of these charts tell us very little about the causation between either fiscal or monetary policy and NGDP. Noah Smith says it best:

Beckworth's conclusion is not necessarily valid, and illustrates the danger in drawing conclusions about structural variables from looking at correlations between macroeconomic aggregates. Here's why the conclusion might not be valid:

Suppose that Keynesian demand management policy works perfectly: in other words, fiscal stimulus perfectly smooths fluctuations in aggregate demand. In that case, you will observe substantial swings in fiscal policy, but no swings whatsoever in aggregate demand. When external shocks push AD up, fiscal tightening will push it back down; when external shocks push AD down, fiscal policy will push it back up.

…

To conclude: The graphs Beckworth shows are perfectly consistent with a large fiscal multiplier. In fact, they are perfectly consistent with the hypothesis that monetary policy is essentially ineffective, that the Fed is basically powerless, and that fiscal policy is capable of doing a perfect job of smoothing NGDP growth all on its own.

Smith’s conclusion similarly applies to the charts depicting Monetarist demand management policy. The point is that these graphs can be subjectively interpreted to support fiscal policy, monetary policy, or neither. These charts may appease proponents of the respective camps, but far more and better empirical data will be necessary to actually change any minds.  


Update: A reader asks for a chart depicting M1 versus NGDP during this period. Always trying to oblige my readers' requests:
If monetary policy affects NGDP, this chart doesn’t reflect it.

Fighting for Endogenous Money on Two Fronts

Yesterday evening, Daniel Kuehn had the following to say in a post about Endogenous money:

I think the whole idea of endogenous money is vastly overrated and the idea of exogenous money is vastly underrated.

...

If you want to say central banks care about interest rates, I'm fine with that. If you want to say that interest rates impact aggregate demand and that influences the broader definitions of the money supply, I'm fine with that. But monetary policy is still done by buying and selling high powered money (as far as I know - I've never talked to someone at the OMO desk), and it's done that way because while causality could run both ways (think of the old use of the discount window or Bagehot's dictums as an example of interest rates "causing" money creation), that's not how it works. Of course there is some target interest rate in mind (and THAT is only what gets churned out of some target inflation rate) - but you buy and sell stuff at the OMO desk because it causes that target interest rate to come to fruition.

My initial response in the comments was that:

Endogenous money is typically about much more than the manner by which central banks perform OMOs. You are correct that central banks typically buy and sell high-powered("outside") money to target a federal funds rate. However, a theory of endogenous money would argue that does little to control the inflation rate or aggregate demand within the economy. Instead, private banks create "inside" money (deposits) through lending that adds to aggregate demand and can create inflation. After lending, banks ensure they meet reserve requirements and the Fed ensures the entire banking system has enough reserves to maintain its target interest rate.

From this perspective, a money multiplier with respect to OMOs does not exist. Further, money and money-like instruments can be perceived as non-neutral, even in the long run. In these ways and more, the distinction between the two theories is far greater than you appear to let on.

(Note: Through QE, the Fed has been buying Treasuries and Agency-MBS, which are not forms of high-powered money)

Since then we have been engaged in some good dialogue back and forth about the merits and actual theory of endogenous versus exogenous money.

Separately, Jonathan Finegold has “a few quibbles” with Edward Harrison’s post on “Endogenous Money and Fully Reserved Banking”:

Second, Harrison writes that bank reserves are irrelevant, because credit demand is endogenously determined; this is true, but  generally since demand for credit is practically limitless, reserves provide banks with the capital to lend. I don’t find it convincing to interpret the causality from loan origination to reserve provision (that is, banks lend and then the central banks provides the necessary reserves).

To which I responded:

As for the second point, the central bank always provides enough reserves (either through OMOs or the discount window) for the entire banking system to meet its requirements. Banks can also borrow/lend reserves to each other through the inter-bank market. Since the discount window entails an excess fee for banks, it marks the known upper bound at which reserves can always be obtained. Under normal, pre-2008, circumstances the Fed would adjust the total number of reserves in the banking system through OMOs to ensure it met its target interest rate. Now that the banking system has substantial excess reserves, the Fed uses IOER policy to set the interest rate and adjusts the amount of reserves to increase liquidity, shorten asset maturities in the private sector and alter expectations.

The theory of endogenous money is a significant departure from exogenous money and mainstream, neoclassical views. This fact makes its acceptance and understanding by people well-versed in the traditional view all the more difficult. Hopefully others will join in the conversations and help turn the tide!

Suggested Readings:
Understanding The Modern Monetary System @ Monetary Realism
Endogenous Money: What it is and Why it Matters by Thomas Palley
Endogenous money - Wikipedia, the free encyclopedia

Related Posts:
Fullwiler - "The main shortcoming of the money multiplier paradigm"
A Stinging Critique of Monetarism
The Money Multiplier Fairy Tale

Fullwiler - "The main shortcoming of the money multiplier paradigm"

Economists and investors are once again getting excited about the potential for Bernanke to signal new monetary “stimulus” during his upcoming speech at Jackson hole. Calls for further action have been coming from all sides over the past few months, while the Fed has remained relatively passive. Although reasons behind the push are varied, many proponents still hold the misguided belief that balance sheet expansion (i.e. increasing reserves) will allow banks to increase the extension of credit. Though some mainstream (e.g. Simon Wren-Lewis) and heterodox (e.g Lars P. Syll and Marc Lavoie) economists have clearly portrayed the myth of the money multiplier, the concept lives on. Continuing my efforts to eradicate this theory, here is Scott Fullwiler from his exemplary paper on Interest Rates and Fiscal Sustainability:

This “money multiplier” view is still prevalent in virtually every economics textbook from the principles level on up to the doctoral level. The main shortcoming of the money multiplier paradigm has been recognized for some time by Post Keynesians and Circuitistes: reserve balances simply are not an operational constraint on bank lending. The money multiplier approach presumes that banks need reserve balances to make loans, but reserve balances can only settle a bank’s payments or aid the bank in meeting its reserve requirement. A loan, on the other hand, is created endogenously at the request of a creditworthy customer and creates its own deposit. As just one example, Moore (1988) notes that the substantial lines of credit banks pre-negotiate with their customers leaves the precise timing and size of their lending outside of their direct control. Again, as Moore explained, if loan creation or uncertain timing of deposit inflows has created an additional reserve requirement for a bank, the bank’s response is to borrow the additional required balances in the money markets. Whereas the money multiplier presumes that reserve balances set the limit on a bank’s lending or money creation, real-world banks instead and necessarily lend first and meet reserve requirements later. (p.12)

This myth is unlikely to go down quietly because, as Philip Pilkington makes clear:

if the money multiplier dies much of neoclassical economics goes with it. As endogenous money theorist Alain Parguez puts it: endogenous money destroys the concept of the scarcity of money, and without the notion of scarcity applied in every economic field neoclassical economics breaks down.

However, until these efforts prove fruitful, I will continue to provide examples to the contrary...

A Stinging Critique of Monetarism

As I approach the start of grad school in a couple weeks, I’ve been focusing more time on reading and writing about ideas that are positive additions to my understanding of the macro-economy and potential policy solutions. This has meant less time devoted to refuting ideas and policies that I believe are empirically incorrect and offer little chance of success in practice. However, Philip Pilkington’s recent three-part series critiquing New Monetarism is simply too good not to recommend here. Through selected quotes from each of the parts, I’ve attempted to highlight Pilkington’s strongest arguments and those most relevant to current monetary policy:

Philip Pilkington: The New Monetarism Part I – The British Experience

The monetarist experiment proved disastrous. The Bank of England failed completely to control the money supply and succeeded only in causing interest rates to spiral out of control. This threw the economy into a deep recession. Between the last quarter of 1978 and the last quarter of 1980 the M3 measure of the money supply – the target of the monetarists – rose by some 32.8%; this was significantly faster than in the years before the targets had been initiated. Meanwhile unemployment skyrocketed and businesses shut their doors.

…

Note the resemblance to today’s QE program. Many in the markets and the media have succumbed to a sort of ‘QE fatigue’ as it is obvious that the policy has not produced the desired effect. Nevertheless, QE continues to live on as a sort of undead policy tool. A great deal of the reason for this is that those engaged in the markets can still trade on QE. For example, if another round of QE is announced by a central bank an investor can short the currency of that country, buy their government bond or throw money at the stock market. The brief increase or decrease, generated mostly by self-fulfilling expectations, can then give their portfolios a boost. Economists and commentators also cling to QE because it gives them something to talk about which they can use to enhance their prestige – this even though QE, stripped of its aura, is a straightforward asset swap program that a child could understand.

Philip Pilkington: The New Monetarism Part II – Holes in the Theory

Friedman was convinced that if he could prove that Keynes was wrong by showing that the velocity of money was relatively fixed and that there was thus a fairly simple mechanical relationship between the money supply and national income, the Keynesian theory would largely fall apart. If Friedman was correct he would also be able to explain inflation as simply being due to the central bank allowing too much money flow into the economy relative to the size of that economy and that all they had to do was target a given money supply to bring the inflation under control.

...

So, what was wrong with Friedman’s basic theory? Well, first of all the correlations he thought he found were not the same across time and space. If the data for many countries is compared across time we see strong fluctuations in the velocity of money. Indeed, even within single countries the velocity of money fluctuates quite aggressively in line with overall economic growth. Here, for example, is the velocity of the M2 money supply in the US charted together with the employment-population ratio – an indicator of economic health that is used to determine the ability of the economy to produce jobs:

 

Clearly the velocity of the M2 is not at all constant and moves in rough correlation with the employment-population ratio and, hence, with the health of the economy. So, Friedman was wrong on even the simplest measure. The velocity of money does, in fact, vary over time.

Does this mean that Keynes was correct and large-scale unemployment could not be cured by monetary stimulus due to a falling velocity? No, not really. Keynes’ idea that the velocity of money would move together with the level of economic activity (and the interest rate) was simply a modification of the old quantity theory of money. Thus all Friedman had to do was show a constant velocity and he could debunk Keynes. But in actual fact, both Friedman and Keynes were using a moribund theory that had no basis in reality (albeit Keynes’ version was far closer to the truth than Friedman’s).

Philip Pilkington: The New Monetarism Part III – Critique of Economic Reason

The report of the Radcliffe Commission was pessimistic in the extreme with regards monetary policy. The commission found that the central bank had little control over the expansion of the money supply and that the velocity of money was extremely variable. Basically, what the commission found was that the banking system was largely passive in relation to the economy. Central banks did not ‘drive’ the economy at all and any policies they did implement, if they were in any way effective at all, would be wholly subordinate to real economic variables such as levels of private investment, consumer demand and government spending and taxation policies.

…

This is arguably where we are today. Quantitative easing is based on the same principles as the monetarist doctrine: increase the money supply and national income will increase with it because the correlations between these two measures can be explained through recourse to a simple, straight-forward channel of causation. And yet once again we have seen the failure of the doctrine – a failure which would have been obvious to Lord Radcliffe and his colleagues. QE has not done what it was supposed to. The banks are flooded with reserves and the money supply has increased drastically, yet national income has not followed suit.

Yet, at the same time, further rounds of QE are still spoken of in solemn tones by central bankers and the media (the markets, however, have been getting a bit sceptical recently…). What’s more, the old monetarist doctrines are still taught in economics departments across the world under the guise of the money multiplier.

The entire posts are well-worth reading, as Pilkington describes the significance of the endogenous theory of money while driving a stake through the theory underlying NGDP Targeting (a primary policy goal/tool of New Monetarists today). The logic outlined here is precisely why I continue to be skeptical of QE-based stock rallies and of the many policies put forth by New (Market) Monetarists. Despite numerous refutations of Monetarist ideals and practical failures throughout history, Monetarism lives on. Pilkington concludes:

Now is the time to allow policymakers and the educated public a look inside. Now is the time for a new Radcliffe Commission to investigate the effects of the QE programs. We can be sure that a bipartisan commission of non-economists who seek only the truth – and not confirmation of the biases with which they earn their crust – can tell us what all this monetary shamanism is actually about.

Hopefully the failed theories of Monetarism can eventually be put to rest once and for all.

For those interested in further thoughts on this subject, here is a sampling of my previous related posts:

NGDP Targeting: Changing Policy Changes Relationships

NGDP Targeting: Changing Policy Changes Relationships (Part 2)
The Money Multiplier Fairy Tale

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.  

IOR Killed the Money Multiplier

Following yesterday’s post that the SNB Massively Increases Monetary Base to Maintain Currency Floor, I became engaged in some back and forth dialogue through the comments at FT Alphaville. In response to a suggestion that the SNB had given up control over interest rates by instituting the currency floor, Philip Pilkington (Naked Capitalism) said:

They could easily maintain control over interest rates by paying a set rate of interest on reserves, just like the US/UK/Japan do with their base rate.

Paying a positive rate of interest on reserves (IOR) would provide a huge incentive for Swiss banks to hold reserves instead of short-term government securities. This swap would move rates on government debt towards the IOR rate (although given the currency floor, Swiss debt may still trade at a relative premium). This discussion of IOR got me thinking:

if the SNB chose to pay IOR, wouldn't that to some degree tighten monetary policy (by making credit more expensive relative to money-like instruments)? If so, might this policy increase deflation and thereby put further upwards pressure on the CHF?

Philip responded:

Maybe. Depends if you think that low interest rates in a ZIRP-like environment actually stimulates demand. I don't think they do to any significant extent. This was shown in the Godley/Lavoie computer simulated models. The effects on investment are short-term -- in the long-term they take away interest income which decreases consumption.

With regards to monetary policy, my views are closely aligned with Philip’s. The strengths of monetary policy are alleviating financial illiquidity and encouraging investment (largely housing) by holding down the long end of the curve. At the moment, US financial markets are highly liquid and housing investment remains constrained by excessive household/mortgage debt, underwater borrowers, foreclosure errors and shadow inventory. Altering rates slightly, in either direction, at such low levels is therefore unlikely to have much impact.  

Moving beyond the economic impact of paying IOR, I decided to pose a question previously alluded to in Permanent Zero: Record Low Treasury Yields and Banking Instability:

Given the amount of excess reserves, will it be easier for central banks to adjust interest targets using the rate of IOR rather than reduce excess reserves back to a level that manages the interest rate target?

Philip confirmed my views noting:

It would, I think, be a great deal easier to use IOR rather than OMO when there are massive amounts of excess reserves (wow, I hope no one ever quotes that sentence!). When/if the recovery happens the central banks may choose to do this instead of engaging in OMOs to soak up the QE-induced reserves. It would be a great deal less hassle provided that central bankers can get over their irrational fear of excess reserves. It would also likely mean that a lot of civil servants currently engaged in OMOs might lose their jobs -- that may sound trivial, but it puts extra pressure on the IOR proponents.

If the central banks did this and conducted their interest rate policy in terms of IOR, the money multiplier would have to die. No longer could any serious economist maintain the myth. But, as I and others have argued in the past, if the money multiplier dies much of neoclassical economics goes with it. As endogenous money theorist Alain Parguez puts it: endogenous money destroys the concept of the scarcity of money, and without the notion of scarcity applied in every economic field neoclassical economics breaks down.

(Philip - My apologies for including that quote)

These comments on the end of the money multiplier brought me full circle to my first encounter with interest on reserves (IOR) back in 2010, when I discussed how the Fed Stands in Own Way on Monetary Policy. In that post I presented the following quote from a  New York Fed report on Why Are Banks Holding So Many Excess Reserves?, by Todd Keister and James McAndrews:

if the central bank pays interest on reserves at its target interest rate,..., the money multiplier completely disappears.

So the money multiplier is dead and even members of our central bank are aware of this fact. Now if only most economists would start accepting this reality...

Update: Ramanan (in the comments) directs us to a power point by Marc Lavoie on Changes in central bank procedures during the subprime crisis and their repercussions on monetary theory. Lavoie provides an important correction to Keister’s views noted above (emphasis mine):

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.

NGDP Targeting: Changing Policy Changes Relationships (Part 2)

Scott Sumner at TheMoneyIllusion suggests that Evan Soltas provides the best argument for NGDP targeting. After offering praise he provides a brief criticism regarding Evan’s interpretation of some graphs in a recent blog post:

Evan states:

The first graph shows that even the most massive amounts of monetary expansion are ineffective medicine for NGDP expansion. What matters is expectations; growth in the medium run is conditional on expectations — not on the monetary base or price level.

The second graph shows the extent to which monetary policy seems to have forgotten this. Nominal income growth expectations have been right at zero since the recession, when before that they had been stable at the 5 percent level for decades. The findings come from this study by the Chicago FRB, which I found through this Chicago Magazine article. Paging Scott Sumner…

Sumner replies:

I mostly agree, and very much like the second graph, but I’d like to slightly quibble with the first graph.  I redrew it setting both the base and NGDP equal to 100 in 1933, not 1929:

Notice that the base rose in the early 1930s while NGDP fell sharply.  That’s because base demand was engorged by two factors, banking distress and ultra-low interest rates.  The ultra-low interest rates continued between 1933 and 1944, but banking distress fell sharply after dollar devaluation and the creation of FDIC.  Thus after 1933 the base and NGDP rose at roughly similar rates, both nearly quadrupling over those 11 years.  As you know, I don’t regard the base as a reliable indicator of the stance of monetary policy, because base demand can be highly volatile under certain conditions.  But the supply of base money is still very important; indeed it’s the major factor driving NGDP over the long term.

Judging this debate I’d actually like to argue that Evan may have the upper hand. Until the Great Recession, excess reserves in the financial system were maintained at a minimal level. As has been previously shown, demand for credit (loans) creates deposits. The Federal Reserve has primarily focused on targeting the price of reserves (interest rates), letting the quantity float by always providing a sufficient amount. The amount of base money should correlate reasonably well with the increasing demand for credit under these conditions. Steve Keen has shown in his models of the economy that changes in debt directly impact aggregate demand and thereby NGDP. One should therefore expect to see a positive correlation between NGDP and base money while those circumstances persist.

However, since the Great Recession the Fed has, to a degree, altered its approach to monetary policy by paying Interest-on-Reserves (IOR). Back in November of 2010 I blogged the Fed Stands in Own Way on Monetary Policy. In that post I highlighted a report from the New York Fed asking Why Are Banks Holding So Many Excess Reserves? As the authors’ note:

if the central bank pays interest on reserves at its target interest rate,..., the money multiplier completely disappears. In this case, banks never face an opportunity cost of holding reserves and, therefore, the multiplier process described above does not even start.

Paying IOR above the risk-free-rate has resulted in a surge of excess reserves and base money uncorrelated with any increase in the demand for credit. Changing Fed policy has altered the conditions under which the previous relationship existed. The supply of base money (which was correlated but didn’t drive NGDP) may therefore no longer even show any material correlation with NGDP (as long as current condition prevail). Evan appears correct:

What matters is expectations; growth in the medium run is conditional on expectations -- not on the monetary base or price level.