On the (ir)relevance of the money multiplier model: The Fed view

It has long been known within the Federal Reserve System -- especially among economists who worked in the FRS in the 1970s and 1980s when much of the research agenda was directed at issues of monetary control -- that the money multiplier model of money stock determination is not the most realistic (or useful) way to understand how central banks conduct monetary policy.

Here is the former Fed Governor, the late Sherman Maisel, during a conference on the theme of 'Controlling Monetary Aggregates' in 1971:

It is clear that, as a matter of fact, the Federal Reserve does not attempt to increase the money supply by a given amount in any period by furnishing a fixed amount of reserves on the assumption that they would be multiplied to result in a given increase in money [...] 

Many unsophisticated comments and theories speak as if the Federal Reserve purchases a given quantity of securities, thereby creating a fixed amount of reserves, which through a multiplier determines a particular expansion in the money supply. Much of modern monetary literature is actually spent trying to dispel this naive elementary textbook view which leads people to talk as if (and perhaps to believe) the central bank determines the money supply exactly or even closely--in the short run-through its open market operations or reserve ratio. This incorrect view, however, seems hard to dislodge. (1971:153, 161)

Briefly, the money multiplier is basically a relationship between deposits (D) and reserves (R), D = mR, (or M = mB) where m is called the money multiplier (or M is money stock and B is the monetary base). According to the model, if banks keep excess reserves to a minimum and reserve requirements are applied to all deposits, then the multiplier can be constant and the central bank -- if it retains control of the volume of reserves -- can control the amount of deposits (Goodfriend and Hargraves, 1983:5). However, if the central bank does not exercise control over the amount of reserves, the multiplier model is inoperable and cannot be exploited for monetary control purposes.

The Classic Fed View

In the US, the Fed's inability to control the quantity of reserves in recent decades (before October 2008) is said to be because of the introduction of lagged reserve requirements in the late 1960s and the Fed's almost continuous use of an interest rate operating procedure.

Former St. Louis Fed economist, R. Alton Gilbert, discussed the impact of lagged reserve accounting on Fed operations in his article "Lagged Reserve Requirements: Implications for Monetary Control and Bank Reserve Management" (1980):

[Lagged reserve accounting] breaks the link between reserves available to the banking system in the current week and the amount of deposit liabilities that banks can create in the current week. If banks increase aggregate demand deposits liabilities in response to an increase in loan demand, they are under no immediate pressure to reduce their deposit liabilities...Under LRA, the Federal Reserve tends to adjust total reserves each week in response to the total deposit liabilities that banks created two weeks earlier. (1980:12)

With lagged reserve requirements in effect the volume of reserves is determined by banking system demand. Reserve demand is simply accommodated and required reserves serve only to enlarge the demand for reserves at any given level of deposits. Under LRA, the change in R occurs as a result of changes in D, the exact opposite of the money multiplier model.

Former Richmond Fed economist, Marvin Goodfriend, discussed the relevance of the money multiplier model when lagged reserve requirements are in effect in his paper "A model of money stock determination with loan demand and a banking system balance sheet constraint" (1982):

...[T]he discussion has shown that the money multiplier is not generally a complete model of money stock determination and is actually irrelevant to money stock determination for some monetary control procedures. Specifically, the money multiplier is irrelevant to determination of the monetary aggregates if lagged reserve requirements are in effect. (1982:15)

As for the other institutional factor relating to the Fed's use of an interest rate operating procedure, Robert Hetzel of the Richmond Fed highlighted the following in his paper "A Critique of Theories of Money Stock Determination" (1986):

Deposits and reserve demand are determined simultaneously with credit creation. As a consequence of defending its rate target, the monetary authority, by creating an infinitely elastic supply of reserves, accommodates whatever reserve demand emerges...In a regime of rate targeting, neither the quantity of reserves nor the desired reserves-deposits ratio of the banking system exercises a causal role in the determination of the money stock (1986:6) [...]

Interest rate smoothing by the monetary authority makes reserves and the money stock endogenous...Since [Chester] Phillips (1921), reserves-money multiplier formulas have been derived from a model of the banking sector summarized in the multiple expansion of deposits produced by an injection of reserves. The existence of markets for bank reserves, however, renders this model untenable. Phillips' model assumes that the individual bank is constrained by the quantity of its reserves and that its asset acquisition and deposit creation are driven by discrepancies between actual and desired reserves. Given the existence of markets for bank reserves, such as the fed funds and CD markets, however, individual banks are constrained by the price, rather than the quantity, of reserves they hold. (1986:20) (emphasis added)

A succinct and detailed discussion of the problems associated with multiplier models of money stock determination is found in the excellent article "Understanding the remarkable survival of multiplier models of money stock determination" (1992) by former Fed economist, Raymond Lombra:

Assuming textbook authors reveal their intellectual and pedagogical preferences and beliefs, a careful survey of the leading intermediate textbooks in money and banking and macroeconomics reveals a uniform and virtually universal consensus – the multiplier model of money stock determination is widely viewed as the most appropriate and presumably most correct approach to the topic...Since such consensus is not, in general, an enduring characteristic of monetary economics, one is tempted to “let sleeping dogs lie”. The problem is that the multiplier model, whether viewed from an analytical or empirical perspective, is at best a misleading and incomplete model and at worst a completely misspecified model. (Lombra, 1992:305) (emphasis added)

Lombra's article is especially useful because it groups together the different critiques of the multiplier approach into two categories (the article discusses a third set of critiques relating to the predictive accuracy of multiplier models but this issue is less relevant for this post). 

The first set of critiques identified by Lombra is that the multiplier model "is not structural but rather is a reduced-form", a point first made in the 1960s by proponents of the "New View" (including James Tobin in "Commercial banks as creators of "money")*. Lombra summarizes this critique as follows:

Succinctly stated, the critique emphasizes that the multiplier approach abstracts from the short-run dynamics of adjustments by banks and the public, leaves the role of interest rates implicit rather than explicit, and proceeds that the movements in the monetary base (or reserves) are orthogonal to fluctuations in the multiplier. The multiplier model, it is argued, implies that deposit expansion is quantity constrained through the Fed's control over the sources of bank reserves (chiefly, the Fed portfolio of securities). One of the most forceful and articulate crafters of the critique, Basil Moore, concludes that "as a result, the money multiplier framework is of no analytical or operational use".

The consensus view of the staff and policymakers within the Federal Reserve, as revealed in numerous publications, embraces much, if not all, of the critique advanced by Moore and others. In particular, the Fed adheres to the view that the system is equilibrated through the movements of interest rates, which through their effects on bank revenues and costs, determine banks' and the public's desired asset and liability positions. In this view, money is controlled by using open market operations to affect interest rates which in turn affect demand and thus the uses of bank reserves (chiefly, required reserves).  (307)

The second set of critiques discussed by Lombra concerns the issue of the endogeneity of reserves, that is, the notion that the quantity of reserves is in practice determined by the banking system:

This contention, which is related to the lagged reserve accounting scheme...and the Fed's interest rate operating procedure in effect for virtually all of the post-Accord period, implies the multiplier model is completely irrelevant for the determination of the money supply. (308)

Lombra's article concludes with a discussion on why, despite these important flaws, the multiplier approach continues to be popular among economists. The reason, he argues, is that when applied to longer term horizons the models track monetary growth reasonably well:

The model lives on with model-builders who are confirmed adherents to the Law of Parsimony and skilled in the use of Occam's Razor. The high correlations and identities so tightly linking reserves (or the base) and money over the longer run provide all the comfort most empiricists need to proceed as if the concerns noted above matter little. (312)

Still irrelevant?

Recently, Fed economists Seth Carpenter and Silva Demiralp concluded in their paper "Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?" that the money multiplier is not a useful means of assessing the implications of monetary policy for money growth or bank lending in the US.

Not only does their paper discuss the institutional factors that render the money multiplier inoperable (including those discussed above), it also demonstrates empirically that the relationships between reserves and money implied by the money multiplier model do not exist.

These conclusions should, however, be viewed with caution given that the period under investigation in the paper ends in 2008, just prior to the Fed's shift toward the use of unconventional monetary policies.

Interestingly, Robert Hetzel now believes that the money multiplier model has actually gained relevance since the Fed started with its large-scale asset purchases in 2008.

Here is an excerpt from Hetzel's recent book, The Great Recession:

Starting in mid-December 2008 when the FOMC lowered its funds-rate target to near zero with payment of interest on bank reserves, the textbook reserves-money multiplier framework became relevant for the determination of the money stock. The reason is that the Fed's instrument then became its asset portfolio, the left side of its balance sheet, which determined the monetary base, the right side of its balance sheet. As a result, from December 2008 onward, the nominal (dollar) money stock was determined independently of the demand for real money. Although the reserves-money multiplier increased because of the increased demand by banks for excess reserves, the Fed retained control of M2 growth. Even if banks hold onto increases in excess reserves, the money stock increases one-for-one with open market purchases. (2012:237) (emphasis added)

In other words, Hetzel is saying that, as a result of its ability to determine the monetary base (B), the Fed now exercises considerable control over the change in deposits (D). And by doing so, Hetzel is suggesting that the Fed -- in one way or another -- is currently exploiting the money multiplier framework.

Here's a chart that appears to support Hetzel's claim:

The chart shows that since 2008 changes in B -- resulting from Fed asset purchases -- are clearly associated with changes in M**. For the period prior to 2008, there is no such relationship.

Hetzel's claim about the relevance of the multiplier approach could help to explain why some commentators have found causal relationships between changes in the monetary base and other variables for the period since December 2008.

For instance, Market Monetarist proponent Mark Sadowski recently pointed to empirical evidence that changes in the monetary base have had some causal role since December 2008:

I’ve done Granger causality tests on the monetary base over the period since December 2008 and find that the monetary base Granger causes the real broad dollar index, the S&P 500, the DJIA, commercial bank deposits, commercial bank loans and leases, the PCEPI, and 5-year inflation expectations as measured by TIPS.

So what's the bottom line? Does this mean the money multiplier model is now relevant?

On the one hand, I'm not convinced the model is entirely applicable (for instance, the textbook treatment implies that banks keep excess reserves to a minimum, which is obviously not the case today). On the other hand, it's unlikely that Hetzel is somehow wrong here.

Fortunately, I don't think it matters much one way or another, unless perhaps you are a Fed technician or an econometrician. What does matter is that the Fed currently exercises control over the monetary base. This, in itself, is a significant development for understanding the policy options now available to the Fed.

One thing is for sure, this recent development provides an excellent illustration of a crucial point often highlighted in Raymond Lombra's work:

The specific procedures ("policy rule") employed by the Fed and the reserve accounting regulations governing bank reserve management play a crucial role in determining causal relationships and system dynamics. (1992:309)

------

* The 'New View' focused on the role of assets, both real and financial, and the relative price mechanism in monetary analysis. From an operational standpoint, it contended that the Fed has little control over the money stock and that the money stock plays only a minor role in the transmission mechanism linking Fed actions to the real sectors of the economy.

** It's clear that the monetary base is not pulled upward due to increased deposit creation by banks.

References

Carpenter, S and S. Demiralp, Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?", Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C.2010

Gilbert, R.A., Lagged Reserve Requirements: Implications for Monetary Control and Bank Reserve Management", Monthly Review, Federal Reserve Bank of St.Louis, 1980:

Goodfriend, M., A model of money stock determination with loan demand and a banking system balance sheet constraint", Federal Reserve Bank of Richmond Working Paper, 1982

Goodfriend, M. and M. Hargraves, A historical assessment of the rationales and functions of reserve requirements, Federal Reserve Bank of Richmond Working Paper, 83-1, 1983

Hetzel, R., A Critique of Theories of Money Stock Determination, Federal Reserve Bank of Richmond Working Paper, 86-6, 1986

Hetzel, R., The Great Recession: Policy Failure or Market Failure, Cambridge University Press, 2012

Lombra, Raymond. Understanding the remarkable survival of multiplier models of money stock determination, Eastern Economics Journal, Vol 18, No 3, 1992

Maisel, S., Controlling Monetary Aggregates, Federal Reserve Bank of Boston Conference Proceedings, 1971

Tobin, J., Commercial banks as creators of "money" 1963

Deficit spending got the US out of the Great Depression: Paul Samuelson on helicopter money

Paul Samuelson, circa 2008 (see here at 1:31):

I'm full of sensible heresies. How do you think we got out -- in Roosevelt's time -- got out of that depression? How do you think the pernicious Adolf Hitler -- inheriting about the same, at least one third unemployment -- got out of it? And both of us got out of it in about the same number of years as you are getting to 1939. If you look at Mrs Schwartz's analysis of that, it's completely remote from the truth. 

This is not how it happened, but this is equivalent to how it happened: somebody invented helicopters. And somebody went to the printing press and printed-off millions and billions of legal tender. And then those helicopters flew over the poorer rural regions and the slums of the city. And it wasn't a problem of whether the money was going to be saved or wasn't going to be spent. It had nothing to do with pump-priming...It had nothing to do with jump-starting. [...] It was not a Federal Reserve operation.[...] 

Now, Mrs Schwartz and her collaborator, who's name I forgot at this moment [laughter], would say "well that helped to keep the M up". That's a joke! [The banker] didn't go out and start making new loans. He acquired more Treasury certificates, which had a yield of essentially zero. 

So we never got out of the Great Depression? Yes, we did. We did it essentially by deficit spending [...] 

The rest of this excellent discussion is well worth a careful listen.

Addendum : An ingenious reader has created a direct link to this excerpt on You Tube (see here). 2013-11-07

The Old Keynesian prescription to get out of a deep recession

In my previous post, I highlighted an article that shows the most promising unconventional monetary policies for boosting ailing economies right now are overt monetary financing and the policy measures advocated by neo-chartalists.

It's worth mentioning that, from a practical standpoint, this is essentially what the traditional, Keynesian IS-LM model would prescribe in a context of high public debt combined with nominal interest rates at the zero lower bound.

A good example of the application of IS-LM toward this end is Robert Gordon's analysis of the difficulties facing Japanese policymakers in the 1990s:

If monetary policy is impotent because it cannot reduce the interest rate any further, a fiscal stimulus is required to end the slump and bring back the output ratio back to its desired level [...]

The low level of the Japanese interest rate created a policy dilemma in Japan. Monetary policy could not push interest rates appreciably lower, yet fiscal policymakers felt constrained in achieving a large fiscal stimulus by the high existing level of the fiscal deficit in Japan and by the fact that the public debt in Japan had reached 100 percent of real GDP. 

However, the IS-LM model suggests a way out of the Japanese policy dilemma... [:] a combined monetary and fiscal policy stimulus that shifts the LM and IS curves rightward by the same amount can boost real GDP without any need for a decline in interest rates [...]

Also, with such a combined policy there is no need for a further increase in the national debt held by the public, since to achieve its monetary expansion, the central bank can buy the government bonds issued as a result of the increased fiscal deficit [...]

Why did the Bank of Japan resist what seemed to be the obvious solution, which was that the Bank buy up the government bonds issued as a result of the fiscal stimulus? This solution, sometimes called "monetizing the debt", would be the real-world equivalent of shifting the LM curve rightward along with the IS curve, in contrast to the increased interest rates that would result if the IS curve were pushed rightward without a corresponding rightward LM movement. Bank of Japan policymakers retreated into the traditional fear of central bankers that monetizing the debt would undermine the Bank's independence and credibility, two goals that are embedded in the structure of beliefs of central bankers. In fact, as a result of rapid inflation after World War II, the Bank is legally banned from buying bonds directly from government, although it is still able to purchase government bonds indirectly through financial markets. 

The traditional reason for the historic reluctance of central bankers to monetize the debt and conduct a simultaneous monetary and fiscal expansion has been fear of inflation. Yet Japan's problem in the late 1990s was deflation, not inflation [...]

While the prescription of the IS-LM model in favor of a combined monetary-fiscal expansion seemed clear, implementing this policy recommendation was blocked by the reluctance of the Bank of Japan's to give up its historic commitment to price stability. (137-138) (emphasis added)

One final word. This type of policy solution goes back a long way. A variant of this mechanism -- minus the IS-LM language -- is even found in (Keynesian) Lorie Tarshis's textbook published in 1947.

Reference

Gordon, R., Macroeconomics, Eighth Edition, 2000.

Which unconventional monetary policies hold most promise?

Kudos to Biagio Bossone, Chairman of the Group of Lecce and former central banker (and circuit theorist par excellence), for his first-rate analysis (see here: part 1 and part 2) of the different types of unconventional monetary policy measures that have been implemented and proposed in the last few years!

Bossone's piece does a fantastic job of presenting the different policy proposals into six distinct categories based on their implied transmission channel and the degree of cooperation between the fiscal and monetary authorities that is required in order to implement the proposed measures.

The main take-away from the analysis is that Bossone finds the proposals that aim to boost aggregate demand via fiscal actions are the most promising. According to Bossone, the benefits of fiscal measures (with or without actions by the monetary authority) are that their effect is more direct than policy measures such as quantitative easing (which works indirectly via its impact on interest rates) or forward guidance (which works indirectly via its effect on the public's expectations on future interest rates).

In the concluding paragraph, Bossone writes,

...this result vindicates the proposed measures to expand the money supply via overt monetary financing or neo-chartalism, which aims to inject new money independently of central banks' interest-rate policies, especially if these are limited by the zero lower bound.

Reference

Bossone, B., Unconventional monetary policies revisited, Part 1 and Part 2, Vox, October 2013

James Tobin on why deflation isn't a cure for unemployment

There's been a lot written lately on why the Pigou effect (i.e., increase in output and employment caused by an increase in consumption due to a rise in the real balances of wealth) isn't a foolproof way around the problem of the zero lower bound. It reminded me of these lines by James Tobin:

Suppose all dollar prices and wages are lower by x per cent. Will aggregate demand for products and for labour be greater? Maybe, because with the same quantity of currency and bank reserves, interest rates could be lower and encourage businesses and households to spend. But in depressions, interest rates may be already as low as they can be; after all, the interest rate on currency cannot be less than zero. Anyway, as Keynes observed, lowering the overall price level cannot reduce interest rates more than the central bank could on its own, with much less social trauma. 

Another possibility, stressed by Professor Pigou, is that owners of assets denominated in dollars feel richer after the purchasing power of the dollar has increased; therefore, they buy more goods. The trouble is that debtors with dollar obligations are correspondingly poorer. There is a small excess of privately owned credits over private debts, the monetary issues and near-money obligations of the central government. But this net credit may not be sufficient to offset the likelihood that increased private debt burdens deter spending more than the corresponding gains in the purchasing power of creditors encourage it. So argued Irving Fisher, my revered predecessor at Yale. Even if Pigou, rather than Fisher, is right, the direct effect of the price level on demand is not an equilibrating mechanism of any practical importance. Certainly, the big deflation during the Great Depression did no good. 

A serious drawback to deflation (or disinflation) as an adjustment mechanism is its perverse effect on aggregate demand. Even if lower prices stimulate demand once prices have fallen, the process of falling prices is destabilizing. If you expect falling prices, you will postpone purchases, preferring to hold money rather than buy goods. For this reason, Keynes and Fisher rejected concerted deflation as a remedy for depression and unemployment. 

Reference

Tobin, J., "Business cycles and economic growth: Current controversies about theory and policy", Bulletin, the American Academy of Arts and Science, Vol. XLVII, No.3, December 1993.

Bankers as public servants

An insightful anecdote by a reader of the American Scholar on how banking has changed during his lifetime:

“Good Fences Make Good Bankers” by William J. Quirk (Spring 2013) reminds me of an experience I had in the 1950s. A final-year law student interviewing for a position with a major bank in Ohio, I had the temerity to ask the interviewer what kind of financial future I might expect in a legal career with a bank. He paused and in measured tones told me that if I was concerned with financial success, I should not go into banking. Banking, he said earnestly, was a quasi-public-service industry, and its primary mission was to protect the funds of its depositors and assist its borrowing customers. 

Can you picture a bank interviewer, with a straight face, uttering these same words to a young job applicant today? (italics added)

Reference

Shapiro, Fred., "Bankers as public servants", American Scholar, Summer 2013.

Janet Yellen most prescient among colleagues

Economist James Tobin once wrote that every policymaker thinks and makes decisions based a model of the economy. Tobin explained that the model need not be a complicated one; it just needs to provide a useful framework for understanding the economy and how it evolves, as well as assist the policymaker in decision-making:

There is really no substitute for making policy backwards, from the desired feasible paths of the objective variables that really matter to the mixture of policy instruments that can bring them about. [...]  

The procedure requires a model -- there is no getting away from that. Models are highly imperfect , but they are indispensable. The model used for policymaking need not be any of the well-known forecasting models. It should represent the policymaker's beliefs about the way the world works...Any policymaker or advisor who think he is not using a model is kidding both himself and us...

This week, the Wall Street Journal published the results of an interesting study examining the statements of 14 policymakers made during the course of the recovery concerning the economy and its outlook. According to the WSJ, the statements of Janet Yellen have been the most prescient (see this clip). In other words, her model of the economy has been very effective at helping her anticipate the economy's prospects during the last few years. According to Jan Hilsenrath of the WSJ, one of the authors of the study, Yellen

...had a model of the economy that worked in this case. She has a model that says when there's a lot of slack in the economy, when there is a lot of unemployment, when there is a lot of idle factories, you don't get a lot of inflation. And that model worked this time around. [...] 

Her fans who want her to become the next Fed chair would argue she's been right before. She was issuing some warnings in 2006 about the housing bubble. She was talking in the 1990s -- you know, when you go to transcripts of Fed meetings -- about froth in the financial markets.

One interesting fact is that Janet Yellen was a student of Tobin (and a good one too).

When Janet L. Yellen was a graduate student in economics at Yale University, classmates quickly figured out that the best way to decipher Professor James Tobin's lectures was to borrow her notes. And long after Yellen received her PhD in 1971, the Yellen Notes--as they became known--served as the unofficial textbook for generations of graduate students. ''She has a genius for expressing complicated arguments simply and clearly,'' says Nobel winner Tobin.

"You want to make sure you have sustainable economic growth? Invest in your kids"

Those words are from Art Rolnick, former senior VP of the Federal Reserve of Minneapolis. They're from a recently released video entitled The Raising of America - Are we Crazy about our Kids?

The basic message of the video is that investing in early childhood pays off in the long run. Here's what economist James Heckman has to say about one of the studies that concluded high-quality early childhood learning is beneficial to a child's performance later in life:

"What did we learn? Many things. It's very successful in terms of the economic performance of the children. For each dollar invested you get back somewhere between 7 and 10 percent rate of return per year over the lifetime of the child. Which is a huge rate of return."

Behind this impressive rate of return are large amount of statistics showing that the children who were enrolled in a high-quality early childhood program performed significantly better in school (and later in life) than those who weren't:

"They found that the children that were in the high-quality program were less likely to be retained in the first grade, were less likely to need "special ed", were more likely to be literate by the sixth grade, graduate high school, get a job, pay taxes and start a family. And the crime rate between the two groups -- the randomized group and the control group -- the crime rate goes down by 50 percent. So those look like pretty good outcomes."

A very smart production.