David Glasner argues the money multiplier is a useless concept. I’m sympathetic to that claim, and yet I think he goes to far in his criticism of Friedman and other monetarists. Although the concept is useless, it’s not wrong, and it’s hard to see how it does much damage. Here’s David:
So in Nick’s world, the money multiplier is just the reciprocal of the market share. In other words, the money multiplier simply reflects the relative quantities demanded of different monies. That’s not the money multiplier that I was taught in econ 2, and that’s not the money multiplier propounded by Monetarists for the past century. The point of the money multiplier is to take the equation of exchange, MV=PQ, underlying the quantity theory of money in which M stands for some measure of the aggregate quantity of money that supposedly determines what P is. The Monetarists then say that the monetary authority controls P because it controls M. True, since the rise of modern banking, most of the money actually used is not produced by the monetary authority, but by private banks, but the money multiplier allows all the privately produced money to be attributed to the monetary authority, the broad money supply being mechanically related to the monetary base so that M = kB, where M is the M in the equation of exchange and B is the monetary base. Since the monetary authority unquestionably controls B, it therefore controls M and therefore controls P.
If I understand David correctly he’s a bit confused about the money multiplier. It is simply a ratio, regardless of what David was taught in school. In his example the multiplier equals k, which is the ratio M/B. But unless I misread him, he seems to believe multiplier proponents viewed it as a constant, which is clearly not true. Rather they argued the multiplier depends on the behavior of banks and the public, and varies with changes in nominal interest rates, banking instability, etc. This is how it’s taught in the number one money textbook, and this is the version Friedman and Schwartz used in the Monetary History, which focuses heavily on explaining changes in the multiplier.
And yet I agree with David that the multiplier is useless, mostly for “Occam’s razor” reasons. Think about the Equation of Exchange:
M*V = P*Y
If you want to model nominal GDP, and M represents M1, then you have to model both M1 and M1 velocity. In that case:
M = k*B
So now the equation of exchange is:
B*k*V = P*Y
But in that case why not skip the middleman, and go right for:
B*(base velocity) = P*Y
After all, both k and V are positively related to the nominal interest rate. You have one thing to model (base velocity), not two (the multiplier and M1 velocity).
In any case, it’s silly to focus on either B or M; focus on the goal/indicator of policy, NGDP. The multiplier doesn’t help you do that, and hence is useless. But if people want to use it, they aren’t making any sort of logical error as long as they understand how it changes in response to changes in interest rates and other variables, and the monetarists were able to do that. The Monetary History is a masterpiece of multiplier analysis.
When people say “there is no such thing as a money multiplier,” they are literally saying there is either no such thing as B, or no such thing as M. Obviously they don’t mean that. Rather they are trying to say “the multiplier is not fixed, as the monetarists and textbooks believe.” Except the monetarists and textbooks didn’t claim it was fixed.
Here’s Stephen Williamson:
The money multiplier is probably the most misleading story that persists in undergraduate money and banking and macroeconomics texts. Take someone schooled in the money multiplier mechanism, and confront them with a monetary system – such as what exists in Canada, the UK, or New Zealand – where there are no reserve requirements, and they won’t be able to figure out what is going on. Confront them with a system with a large quantity of excess reserves (the U.S. currently), and they will really be stumped.
Interesting. I wonder if Friedman was “schooled in the multiplier mechanism”? David Glasner says he was. And yet Friedman obviously would not be perplexed by either a lack of reserve requirements or massive quantities of excess reserves. In fairness to Williamson, most undergrads would be perplexed, but then they are perplexed by lots of things. I don’t think my students would be perplexed.