The Money multiplier trilogy (Part II: Resurrection)

After being killed, it is worthwhile to wonder if the Money multiplier deserves a second chance.

I think it does.

So gather round the Dragon Balls because the Money Multiplier is going to be resurrected.

First things first. Why did the multiplier died, again?

Banks don’t need Reserves to make Loans! Loans create Deposits!


So, do Central Banks supply whatever the amount of reserves Commercial Banks need (to comply with legal requirements, to settle payments or to face cash withdraws) ?

Yes and no.

Yes, in the short run they do. They normally establish a interest rate target, so if they don’t comply with quantity demanded of reserves by Commercial Banks, it would lead to financial havoc as interest rates diverge from their targets.

No, Central Banks have a goal for inflation (or NGDP or …) so they must adjust their intermediate target for interest rates in a way they can achieve their ultimate goal.

So, it’s true to say both Reserves and Interest Rates are endogenous, a trustworthy central bank will only set its ultimate goal as exogenous.

Even though a Commercial Bank is not (usually) reserve constrained, as it can look for reserves in the inter-bank market, or can go to the Central Bank (either by discount or overdraft), it faces uncertainty towards the future.

Uncertainty about the “loyalness” of its depositors, uncertainty about the demand for cash, uncertainty about the demand for non-bank assets. A bank must face the uncertainty of its “usual business” liability side (Deposits) with both the “unconventional” liability side  (Central Bank lending) and the liquidity of its Asset side of the balance sheet.

Banks face restrictions. They don’t possess a widow’s cruse.

The Central Bank creates some of those restrictions. The competition among financial assets create some of those restrictions. The Economy creates some of those restrictions.

My goal is to combine the three theories of banking in a unified one (credit creation theory, Money multiplier, financial intermediary). I believe they must be all the same.

Those 3 theories can be matched with the 3 restrictions stated above. The 3 theories are all different angles of the same reality.

Banks create Money through credit. Yes.

The Central Bank influences the credit creation by supplying Reserves. Yes.

Banks are in the end of the day, just financial intermediaries. Yes.

My next post will try to create a comprehensive model which puts together the 3 theories, which in my view (with some assumptions) will grant a simplified but general view of how Banking and Central Banking works.

Let´s try to give the multiplier, Immortality.

(and create another multiplier during the process)


The Money Multiplier trilogy (Part I: Death)

The Money Multiplier is one real beauty when you start to learn Monetary Economics (most probably from Mishkin textbook). It makes you feel wise, you DO understand how Central Banks influence the Money Supply and Bankers are only pawns in this magnificent Game of Thrones of the Economy in which the Central Bank reigns supreme.

But “they” are trying to kill it!

Everyone, from Monetarists to Keynesians.

Even though in a way or another, most economists still believe in some version of the Money multiplier it’s uncool to express it that way, and you will soon find yourself ridiculed by someone who really understands banking.


I must confess my sins. I too believe the multiplier is dead.

Just look at this graph:


Bernanke killed the Money multiplier!! Quantitative Easing exposed the “truth”!

What are the problems/wrong assumptions of the Money multiplier?

  1. Normally, central banks just “follow along” the demand for reserves, so instead of a “monetary policy driven injection of reserves” Money multiplier, it really is kind of a “Money divisor” as banks look for reserves after they create loans (and deposits). And Central Banks must accommodate the banking system expansion if it wants to ensure financial stability.
  2. A straw man version of the MM assumes Banks lend reserves. This is not true. (as it may be explained later)

So, the Money multiplier has been disproved by Central Banks operations during the crisis as by some “endogenous demand driven vision of the economy”.

But still, I still believe in its beauty and we should not mourn its death, because I know it will rise again, and stronger than ever.

Nick Rowe is not alone in this fight.

Let me do my best to try to defend (my version) of the Money multiplier.

The real real interest rate

Economics is all about price determination.

At least since the Great Knut (Wicksell) we started to see the Interest Rate as the Price.

It was the most important price in the economy, its determination would set the course of economic development, both in the short as in the long run.

We still live in a Wicksellian world. Ask any Central Banker. Better yet, ask Michael Woodford, one of the leading macroeconomists.

But this post is not really just about interest rates.

It’s really about Real interest rates.

Since the Great Irving (Fisher) we learned to differentiate between the real and the nominal interest rate, so to avoid the Money Illusion.

The real interest rate is (roughly, only for small numbers) the nominal interest rate minus the ex post inflation rate. (Remember that, when we compare current interest rates with inflation this is not correct. Current interest reflects the gain we shall have in the future, current inflation reflects the loss of purchasing power in the past).

Simple example:

Savings Deposit offering 10% interest rate. Inflation rate (future) would be 20%.

Although we are 10% richer (in nominal terms) next year, we would buy less 10%of goods (to be correct is less 8,33%).

So I guess, we can say, the lower the real interest rate the higher is the incentive to avoid saving (consume). Because, and this is the main point: TO SAVE IS TO DELAY CONSUMPTION.

But at the opposite side of the coin, we have Investment.

And if we follow the same logic, the lower is the real interest rate, the higher is the incentive to Invest.

But we would be wrong (at least partially). The goal of investing is to achieve the highest possible return.

And the evolution of returns does not follow the inflation rate. That’s the main difference.

Another example.

Imagine you borrowed at 10%.

Inflation would be 20%.

Therefore we shall have a -8.33% real interest rate and therefore an incentive to invest. Right? Wrong.

Why is it wrong this time? Because nobody invests in CPI baskets.

Imagine you invested in iron, which had a 30% increase in prices. You should use iron inflation to deflate the nominal interest rate. This would lead to high incentive to invest.

Imagine you invested in oil, which had a 30% decrease in prices. You should use oil inflation to deflate the nominal interest rate. This would lead to low incentive to invest.

(Things could get really tricky, but I dont want to go that way)

Imagine you borrowed at 5% to buy something that increased its price at 10% and your income increased 5%.

Well, what really matters is nominal income growth then? Hurray for the Market Monetarists and most particularly to Geoge Selgin? (future post).


All that really matters is that we really should know what a real interest rate really is.

Enough for today.

Two residuals multiplied become an illusion

You are a Monetarist.

You think Y=C+I+G+NX is just an identity, it doesn’t tell you much.

You believe fiscal policy is ineffective.

You believe the Keynesian multiplier is Zero.

You believe in the Sumner Critique.

Hence, the multiplier is nothing more than an ILLUSION, the shadow of Central Bank incompetence.


You are a Keynesian.

You believe fiscal policy is effective.

You believe monetary policy is effective (except in the Zero Lower Bound).

Monetary Policy is conducted through variations in the Monetary Base (which may affect interest rates).

You think M=mB is just an identity, it doesn’t tell you much.

Hence, the Money Multiplier is just a RESIDUAL.

You think MV=PY is just an identity, it doesn’t tell you much.

Therefore, the Money Velocity is just a RESIDUAL.


Let’s all be friends again?

Imagine two things:

You have a lot of unemployed resources in the economy, so an expansionary policy will only move Y (P is fixed).

You shall use a Helicopter Money. A Money Financed Deficit. Monetization. Whatever you want to call it.

Basically the Government spends newly-printed (or newly electronically  created) Monetary Base.

What will happen???

Hyperinflation!!! Zimbabwe! Weimar!


Let’s build an example.

So, we have have dG= 1000 and dMB =1000.

The increase in Government Spending somehow (magic?) increases Output (Y) in 3000.

So… the Keynesian multiplier (dY/dG) of the increased spending would be 3.

Shall we continue? Of course.

We  know mBV=PY. We know P is constant (assumption), we know the Monetary Base increased 1000, and Real Output increased 3000 (multiplier effect).

So..By definition, we must have that the effect of the Money multiplier and Money velocity should lead to an increase in Output of 3000, given the increase of 1000 in the Monetary Base.

Basically the expansionary effect will be the result of the Money multiplier and the Money velocity, which must “multiply” the increase in Monetary Base by….3.

Some caveats:

  1. We can’t (in this model) disentangle which (V or m) “multiplies” the Monetary Base into Real Output, we must assume it’s a combination of both the indicators
  2. The Keynesian multiplier is about a flow, (an increase in GDP), the Money multiplier and velocity are about a Stock (the Money stock), so in this example both the multiplier and velocity represent variations of the Base (flow)

But in the end of the day, we can say this:

(Using flows, using deficit monetization and assuming fixed prices)

The Keynesian Multiplier is equal to the Money Velocity times the Money Multiplier

Or as I said in the tittle

Two residuals multiplied become an illusion

Are you a Socialist or a Communist??

Or do you just want to see the world burn?


(This post builds on ad absurdum arguments, if you are not able think “theoretically”, this one is not for you)

Imagine the mother of all crisis!

This is not the Great Recession! This is not the Japan Crash! Not even the Great Depression!!!

All people stop consuming in large scale, all companies stop investing! Unemployment reach maximum peaks! Why? Oh..forget why.. Let’s call it…the animal spirits, a decrease in confidence, whatever…that’s not the point.


At least we have a Central Bank, some will shout!

At least we have a Fiscal Authority, others will scream!

Let’s start with the first ones: What would the Central Bank do? It would start buying Short Term Treasury Securities (or define a short term interest rate), but then suddenly the interest rate reaches the Zero Lower Bound (or another bound..) and they decide to buy longer term bonds, until the interest rate reaches zero too! Then it will go to corporate bonds! Stocks! Houses? What else??

The Central Bank just bought everything…and still no resurgence in private spending to acceptable levels.

Did the Central just buy everything? And the Central Bank is part of the Government, right? So if the Government owns all the assets in an Economy…

Those who shouted for Monetary Policy ended up as Communists! (Friedman would not be happy about this – neither would Sumner)

What about the ones who called for the Fiscal Authority?

Well…Let’s say, first of all, the Ministry of Finance cuts taxes all the way to zero… resurgence in private spending to acceptable levels.

What else? Well..Government Spending it is!

The Government will just Deficit Spending all the way to prosperity, choosing the sector in which to spend/invest as it would seem fit. It would choose the direction of the economy!!

What? Those who shout for Fiscal Policy ended up as Socialists! (I guess both Keynes and Krugman wouldn’t mind…) the end,  are we all just Socialists or Communists?

No..You could just shout (as Mises): “YOU’RE ALL A BUNCH OF SOCIALISTS” and watch the world burn.


P.S: I know, I know.. I maybe distorted a little the meaning of socialism and communism, but if the great Nick Rowe can (but much better), so can I, right? (Wrong)

Scott Sumner, semantics and bias

Scott Sumner is referred by some as “the economist that saved the economy”.

He is kind of an hero to me, because he rose from the blogosphere and became one of the most influential economists nowadys.

In a recent entry in his blog, he refutes Old Keynesianism based on Japan.

I don’t think he is completely right, and maybe his “libertarian” bias is leading him to the kind of semantics error that he so hard tries to fight (regarding monetary policy).

Let me explain.

(My apologies in advance if you don´t agree with what I think you believe, Scott)

A macroeconomic policy is the set of policies that are taken by the Government (and/or Central Bank) to achieve some macroeconomic targets (employment, inflation, NGDP,…).

Scott thinks the best target is Nominal Gross Domestic Product (or some proxy). I agree.

Scott thinks monetary policy is the best policy to achieve that target. I agree, most of the times.

Scott thinks that although fiscal policy may have some macroeconomic effects, it is highly ineffective and subject to various kinds of political incentives, that should reduce its use to bare minimum. It should reduce its use to microeconomics purposes and not to stabilization. I do agree, most of the times.

So, Scott doesn’t think of fiscal policy as a macroeconomic policy. But Keynesians do.

And when he tries to play the “Keynesian game” and tries to refute them, he falls to same type of fallacy Keynesians fall in terms of monetary policy.

“it’s one of the most expansionary fiscal policies in all of history coinciding with the worst performance of aggregate demand ever observed in a major economy”

If you replace “fiscal” with “monetary”, Scott would roll over his eyes (probably).

As Scott would deem monetary policy in Japan since the 1990s highly contractionary (by the bad performance of the economy), despite low interest rates, it’s legitimate that Keynesians see fiscal policy as highly contractionary, despite high fiscal deficits. Just ask Richard Koo.

Maybe fiscal policy is Japan is being highly ineffective, but maybe because it’s not being applied the right way.

Maybe Quantitative Easing (the first round) in Japan was highly ineffective, but maybe because it’s not being applied the right way.

I guess this is all for today. But I will publish more on this topic during the week.

A simple IS/LM type of model but regarding fiscal policy.

NGDP and other mistakes

This will be a simple post.

First of all, I must recognize (after a post criticizing Market Monetarists) that  NGDP targeting is one of the most sensible policy options that a Central Bank must pursue.

I still doubt Central Banks can efficiently achieve it in some cases (distorting asset prices in deep recessions) and still think it must be well studied which should be the target per se. (why 5%?).

I guess, the main change in my opinion came from David Beckworth (among other Market Monetarists) whom advises that a NGDP target instead of an inflation target is capable of disentangle the effects in inflation of Demand and Supply shocks.

A Central Bank is supposed to react to Demand Shocks but not so much to Supply Shocks.

(I say not so much and not entirely because if the shock has a great amplitude and leads the economy to severe inflation/deflation, it is still the Central Bank duty to avoid Debt/Deflation problems and other high inflation problems).

If the Fed had followed a NGDP targeting policy it would recognize that the decrease in inflation in 2002 was a sign of a positive supply shock and not a negative demand shock.

It would then avoid decrease its interest rate (expansionary policy as the natural rate should have been increasing with the positive supply shock) and maybe…just maybe, avoid all the debt build-up that led to the Financial Crisis.

Speaking of natural rate, I must admit I made a mistake in my post about r* (the Wicksellian natural interest rate). This interest rate isn´t the one that equals GDP to its potential (natural level/whatever), it is the rate that equals GDP to its natural level IF we start from that position (without an output gap).



David Ricardo, Alan Blinder and “being an economist”

Alan Blinder’s book Central Banking in theory and practice is a great “little book”about Monetary Policy.

But my favorite quote in the book is by far:

“…I always harbor doubts about my economist friends who tell me they mow their own lawns, rather than hiring a gardener, because they actually enjoy cutting grass. Such a claim is suspect on its face. But more to the point, a true believer in comparative advantage should be constitutionally incapable of enjoying such activities; the David Ricardo inside him should make him feel too guilty”

Well..I certainly do have a David Ricardo within me (not only in my name), but I guess if the guy really enjoys mowing is lawn, the Greatest Economist wouldn’t frown about it, because..hey it’s leisure!

But a true believer in David Ricardo, a true economist, will avoid at all costs doing something he does not like. He shall specialize in “that thing” he is better (or  less bad) and buy everything else from another “specialist”.

And that’s what I like to think, when someone calls me lazy…

I am not lazy, I am a true Economist!

(Of course I am lazy), but at least I am following the footsteps of the Great David Ricardo!

Market Monetarism

Market Monetarism is maybe one of the greatest hypes recently as a school of economic thought.

Hell, IT even was created within the Blogosphere.

Lars Christensen coined the term and he is among a superclass of economists (and some of my favorite bloggers) comprised of Scott Sumner, Nick Rowe, David Beckworth, Marcus Nunes, among others (sorry..).

Although I learned a lot from the blogs of the economists previously mentioned, I still have some problems with MM (Market Monetarism), maybe it’s because I am not yet fully aware of the whole scope of the “School”, maybe it’s some difference in the way they present their ideas, maybe (throwing away all humility) it’s because they are not totally right… Who knows?

But in the end of the day, it’s a win-win situation. If I’m right, hurray for me. If I’m wrong, I learned something today. And I guess the MM gods, would cut me some slack as I am still young and naïve!

First off, the compliments:

I guess the main contribution MM has gave me (yet) was the subject of my latest post, the difference between an easy, easier or easing monetary policy. (I hope they agree with me though, as I used a different methodology comparing to MM).

The hot potato effect also was a great analogy of the monetary mechanism (Sumner). As were all the analogies made by the great Canadian economist Nick Rowe. The case of commodity exporters and their exchange rates was a great enlightenment by Christensen (although I was starting to see the light in a previous post of mine – the oil-exchange rate paradox). I guess there are lots of other great ideas that I derived from MM.

And one can never forget David Beckworth, whose MacroMusings podcast is the greatest thing since slice bread! (at least for economics’ nerds).

But the greatest contribution from MM is NGDP targeting, I guess one could call them NGDPpers instead of MM (although to be fair some MMers prefer other targets).

The main idea is to kindly forget Old Monetarism, velocity is unstable and the money supply is a hard defining measure. Let’s focus on the YP (=MV), let’s focus on the Nominal Gross Domestic Product.

Well…it really does seem awesome to give the economy some nominal stability.

And I do believe that the establishment of Interest on Reserves was an contractionary policy. Although the decision was made to change the “way of doing business” in the Fed and not as contract the economy.

But now I will present all my doubts/concerns/problems with MM:

First of all, which should be the NGDP growth target? 5%? Why? Should it change through times? Which should be the criteria? Historical average?

A 2 % inflation rate target, I get it (although I don’t buy it)! » This was another insight MM gave me (but I’ll focus on it in a future post). But I find it hard to settle a NGDP target.

Second: Let’s assume for the sake of argument, that Central Banks indeed can fully control NGDP (and they are currently being very stubborn).

If they do, I don’t get it how will there ever occur recessions again.

Oh.. this is hard to explain, maybe because I am wrong, but bear with me..

If the Central Bank faces a real or financial shock (Lehman for example) it would use an expansionary policy (a “real” expansionary policy, not like a Bernanke policy as a MM would say). What would happen then?

The injection of money supply will avoid the recession up to the point that the recession is avoided (without the rise in consumer price inflation). This is what I don’t get, Sumner would say that the Fed would create inflation during the recession to maintain the NGDP growth.

But a recession with inflation (stagflation) shouldn’t be only caused by “cost-push factors” (yeah, Post-Keynesian I know) instead of being caused by expansionary monetary policy?

Can the Central Bank cause stagflation? To maintain nominal stability?

I don’t think so… (I may be wrong), so the Central Bank policy would avoid the recession. (Don’t go away yet, please)

In the same line of thought, during the recession if the Government follows an expansionary policy, real GDP will rise instead of inflation, the Central Bank will not react, Krugman would be right (and all the other Keynesians and Quasi-Keynesians) and the Sumner Critique would not apply.

My third question… is… How???

Here comes the hot potato effect, and it really makes sense, but I think it is not being applied the right way (let’s see).

But first let’s assume away Helicopter Drops, these would turn invalid all my next comments, but I guess Helicopter Money is still not yet being (officially) implemented.

So… Monetary policy works through Open Market Operations. Through the Banking System (here is probably the problem).

If the Central Bank wants to expand monetary policy, it buys TBills. Up until the point of the Zero Lower Bound (oh nooo!!). Then it may start to buy longer term bonds, then corporate bonds, then stocks. As Sumner would say, Central Banks have an infinity of assets to buy. Agree. (I hope MMers would too).

But now lays my problem. When the Central Bank buys assets from a bank, it is increasing its asset side of its balance sheet, increasing its liabilities by increasing reserves for the commercial bank. The monetary base does indeed expand. The price of those assets increase.

But then, the excess reserves become a “Hot potato”, every bank wants to get rid of it, but the banking system can’t.

First off, let’s see how the amount of excessive reserves can decrease:

  1. The Central Bank reverts its buying. Or sells other stuff, like foreign reserves.
  2. The Government increases taxation (or reduces spending). This would lead to an increase in the Liabilities to the Government in the CB balance sheet, but a decrease in the excessive reserves (maintenance of the Monetary Base)
  3. The Central Bank increase the ratio of required reserves
  4. The banks decide to increase their lending, and so part of the excessive reserves become part of the reserves requirement (but the level of total reserves is maintained)
  5. People want more cash, the banks would have to “ask the Central Bank” for more notes and coins and give Excessive Reserves in exchange.

So, my main point is: the monetary base does not transmit itself directly to the economy (the Keynesian inside my head is shouting, only if it affects interest rates or…let’s say it: animal spirits). We can say that somehow the increase in MB would lead people to ask for more credit, but I doubt that will happen per se (as we can see in the US, Japan, UK, EZ…).

And if it happens this away, it will have a negative effect in the money multiplier. Monetary base will increase, but the monetary aggregates…not so much.

But…. I still believe it is effective (I may be called Ricardo, but I am no Koo). And the money multiplier will slowly return to its “normal value”.

How? Well… the expansionary policy will increase the price of assets so much (as foreign exchange would be the best example-devaluation: It would be really hard doing it by buying foreign currency, because it will be a Beggar thy Neighbor policy and it’s not usually well seen between countries.) that eventually….that increase in wealth will flow to the real economy by more consumption, investment, exports…and we avoid the recession.

Or maybe we don’t, because monetary policy works in long and variable lags, as Milton Friedman, the Monetarist superstar would say.

Ok…But now the Austrian within myself will say: Blasphemy! You are all discretionarily and deliberately distorting asset prices!!  You will create a Boom and a Bust!!

If you see an Austrian economist saying this about MM and monetary policy, kindly ask him:

So…would you prefer Fiscal Policy? (Be polite afterwards, as he twitch).

My main point is: Monetary policy is effective but not much efficient (in THIS case, the ZLB…the liquidity trap or any other expression you prefer) because it may distort too much asset prices.

Finally, my last problem with MM is, Was Greenspan and Bernanke doing everything alright and then suddenly BB said: “Let´s see what would happen if I try to mess with NGDP. Will I cause a Depression?”?

And then “the” market lost confidence about the FED? And about the BoE? And the BoJ? And the ECB?

Sorry…but this is too hard to try to even imagine (maybe it’s my fault)

Ufff this is a long post…

But I guess it touches on everything I have a problem with in Market Monetarism.

I am ready to be destroyed by some great economists now.

P:S: the “don’t reason from a price change” is also a great insight I learned from Scott Sumner

Monetary Policy and Semantics

When you’re an economist, you have to be very clear about your topic. Otherwise, the “mortals” (non-economists) will misjudge your judgement (and unfortunately some economists will too).

What I will talk about today is the definition of easy/tight monetary policy.

I guess this may be one of the most common “facepalms” topics by Scott Sumner, the Market Monetarist guru.

Was the fall in interest rates in 2008, monetary easing?

Were high interest rates in Weimar, contractionary?

I’ll try to make everything clear (because it really is pretty confusing) and I’ll try to avoid any mistakes…but hey, what can I do?

First of all, you would have to define a comparison point:

If you are a Keynesian, you will (most probably) call it full employment.

If you are a New-Keynesian/Wicksellian, you will call it the natural rate of interest.

If you are a Monetarist you will call it your Monetary Target.

If you are a Market Monetarist you will call it your Nominal GDP target (or wages target or whatever..).

If you are a Marxist you will call it Revolution!!

And if you are na Austrian, you’ll wonder why is the Government sticking its nose where it’s not called for.

I’ll stay with the mainstream for today, so the Natural Rate it is. (Hurray for Knut!)

Let’s imagine the Fed lowers its interest rate from 5% to 0%. What kind of policy is this? (easy=expansionary; tight=contrationary).

First of all, most people will cal it “easy money”, because 0% is “free money”, right? Wrong.

If the natural rate is below 0% we have a tight policy, if it is exactly 0% we have a neutral policy stance, and only if the natural rate is above 0% we would have an expansionary policy.

Yeah..right, but the Fed lowered its rate by 5 p.p., so the policy may not be easy, but at least the Fed is “easing it”, right? Wrong again! Imagine the natural rate has fallen by 6 p.p., and you would have the Fed tightening (2008 anybody?).

For conclusion, let’s cut some slack. We can at least say that, if the Fed reduces its interest rate (ceteris paribus) this is an easier policy than not moving the rate at all. (this is what everybody that says the above mistakes usually means).

Semantics is important! Unless you want to make economists roll their eyes.