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.

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.