If you are teaching or taking an introductory macroeconomics course this fall, you will, at some point, encounter the money multiplier. The multipier posits that there is a stable ratio between M2, the stock of ordinary money in the economy, which consists of currency and bank deposits, and the monetary base, also known as high-powered money, which consists of paper currency issued by the Fed plus reserve balances that commercial banks hold on deposit at the Fed.
textbook will go on to explain that the money multiplier gives the Fed
great power over the economy. The Fed is able to use open market
operations (purchases and sales of government bonds) to control the
monetary base. The monetary base, in turn, serves as the raw material
from which banks create ordinary money for the rest of us. If the money
multiplier has a value of, say, eight, then banks can and will create
eight dollars of deposit money for each dollar of high-powered money.
Add in the assumption that the quantity of money in circulation
powerfully influences investment and consumption spending, and you can
see why we obsess so much about quantitative easing, who will win
appointment as the Federal Reserve Chair, and every comma in every press
release that issues from the stately Eccles building on Constitution
There is just one problem. As the following chart shows,
something has gone badly wrong with the money multiplier in recent
years. For most of the 1990s and 2000s, it was steady as a rock. From
1994 to 2007, the 12-month moving average of the multiplier stayed in a
narrow range, between 8.0 and 8.4. Then it fell off a cliff. By July of
this year, it had reached a record low of 3.24.
happened? To answer that question, we need to look a little more
closely at the textbook explanation of how the money multiplier is
supposed to work, at some features of the banking system that the
multiplier model downplays, and finally, at some recent research. >>>Read more