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The money multiplier – neat, plausible, and utterly wrong

Lars Syll

The mainstream textbook concept of money multiplier assumes that banks automatically expand the credit money supply to a multiple of their aggregate reserves. If the required currency deposit reserve ratio is 5%, the money supply should be about twenty times larger than the aggregate reserves of banks. In this way, the money multiplier concept assumes that the central bank controls the money supply by setting the required reserve ratio.

In his book Macroeconomics, just to take an example, Greg Mankiw writes:

“ We can now see that the money supply is proportional to the monetary base. The factor of proportionality … is called the money multiplier m … Each dollar of the monetary base produces m dollars of money. Because the monetary base has a multiplicative effect on the money supply, the monetary base is called high-powered money. “

The money multiplier concept is as can be seen from the quote above nothing but one big fallacy. This is not the way credit is created in a monetary economy. It’s nothing but a monetary myth that the monetary base can play such a decisive role in a modern credit-run economy with fiat money.

Credit: Source article

In the real world, banks first extend credits and then look for reserves. So the money multiplier basically also gets the causation wrong. At a deep fundamental level, the supply of money is endogenous.

One may rightly wonder why on earth this pet mainstream fairy tale is still in the textbooks and taught to economics undergraduates. Giving the impression that banks exist simply to passively transfer savings into investment, it is such a gross misrepresentation of what goes on in the real world, that there is only one place for it and that is in the garbage can!

Source: Real World Econ Rev, 6 Feb 2023

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