{"id":9574,"date":"2010-05-07T19:27:10","date_gmt":"2010-05-07T08:27:10","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=9574"},"modified":"2010-05-07T19:27:10","modified_gmt":"2010-05-07T08:27:10","slug":"teaching-macroeconomics-students-the-facts","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=9574","title":{"rendered":"Teaching macroeconomics students the facts"},"content":{"rendered":"

\t\t\t\tYesterday, I was walking over to the library and I ran into an old colleague who has been dragooned back into teaching macroeconomics on a casual basis. The person was telling me that they were dreading taking the class next week because the topic was banking and the relationship between reserves and the money supply. Accordingly, the person said the chapter in the textbook specified by the lecturer-in-charge was about the money multiplier. The person I met is familiar and sympathetic to Modern Monetary Theory (MMT) and posed the question “how can I do it?”. My answer was that students deserved better and that the lecture should develop the multiplier from a critical perspective so that students know about it but realise how far-fetched it is as a depiction of how the banking system actually operates.
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\nAs background, I should add that I am no longer associated with the teaching faculty at the University and hold a research chair outside of the teaching and faculty structure. The research centre I direct is within the Research Division of the University. Soon after I left what was then the Economics Department, the neo-liberal managerial onslaught that is rife within Australian universities collapsed the economics discipline into a business school and wiped out a lot of the “social science” component of the program. The strongly Modern Monetary Theory (MMT) and Post Keynesian teaching emphasis of the past has been largely lost and those in charge of teaching macroeconomics here are mostly mainstream (using Dornbusch of all things as the textbook – its about as bad as Mankiw!). It is a very sad outcome for students.<\/p>\n

Anyway, I also mentioned to the person that I had just that morning been reading a rarely cited 1963 paper Commercial Banks as Creators of “Money”<\/a> – by Nobel Prize winning economist (the late) James Tobin. I had read it a long-time ago while I was doing my PhD and was alerted to it again by one of the regular billy blog readers (thanks Jeff).<\/p>\n

The article considers the money multiplier by juxtaposing the “Old View” and the “New View” of banking. I went back into my database to see the notes I took when I read the article originally (in 1983!). It is quite amazing that articles like this get lost in the mainstream literature. Despite obvious flaws they categorically demonstrate that the material that is presented in macroeconomics textbooks and which students subsequently take away from their studies as “truth” is typically misleading and often totally wrong.<\/p>\n

Tobin begins:<\/p>\n

\nPerhaps the greatest moment of triumph for the elementary economics teacher is his exposition of the multiple creation of bank and credit deposits. Before the admiring eyes of freshmen he puts to rout the practical banker who is so sure he “lends only the money depositors entrust to him.” … [in fact] … depositors entrust to bankers whatever amounts the bankers lend … [for] … the banking system as a whole …. a long line of financial heretics have been right in speaking of “fountain pen money” – money created by the stroke of the bank president’s pen when he approves a loan and credits the proceeds to the borrower’s checking account.\n<\/p><\/blockquote>\n

In the blog – Money multiplier and other myths<\/a> – I provide an elementary account of the money multiplier that is taught to students. This is a central mainstream concept which underpins its view that inflation results from budget deficits and that the central bank can control the money supply.<\/p>\n

The mainstream macroeconomics textbooks tell students that monetary policy describes the processes by which the central bank determines the money supply. In Mankiw’s Principles of Economics (Chapter 27 First Edition) he says that the central bank has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system” and the second “and more important job”:<\/p>\n

\n… is to control the quantity of money that is made available to the economy, called the money supply<\/strong>. Decisions by policymakers concerning the money supply constitute monetary policy<\/strong> (emphasis in original).\n<\/p><\/blockquote>\n

They link this alleged capacity to control the money supply to inflation via the belief in the now-discredited but still prominent Quantity Theory of Money. <\/p>\n

Textbooks like that of Mankiw mislead their students into thinking that there is a direct relationship between the monetary base and the money supply. They claim that the central bank “controls the money supply by buying and selling government bonds in open-market operations” and that the private banks then create multiples of the base via credit-creation.<\/p>\n

Students are familiar with the pages of textbook space wasted on explaining the erroneous concept of the money multiplier where a banks are alleged (according to Mankiw) to “loan out some of its reserves and create money”. As I have indicated several times the depiction of the fractional reserve-money multiplier process in textbooks like Mankiw exemplifies the mainstream misunderstanding of banking operations.<\/p>\n

Allegedly, the money multiplier m<\/em> transmits changes in the so-called monetary base (MB<\/em>) (the sum of bank reserves and currency at issue) into changes in the money supply (M<\/em>).<\/p>\n

Students then labour through algebra of varying complexity depending on their level of study (they get bombarded with this nonsense several times throughout a typical economics degree) to derive the m<\/em>, which is most simply expressed as the inverse of the required reserve ratio. <\/p>\n

So if the central bank told private banks that they had to keep 10 per cent of total deposits as reserves then the required reserve ratio (RRR<\/em>) would be 0.10 and m would equal 1\/0.10 = 10. More complicated formulae are derived when you consider that people also will want to hold some of their deposits as cash. But these complications do not add anything to the story.<\/p>\n

The formula for the determination of the money supply is: M<\/em> = m<\/em> x MB<\/em>. So if a $1 is newly deposited in a bank, the money supply will rise (be multiplied) by $10 (if the RRR<\/em> = 0.10). The way this multiplier is alleged to work is explained as follows (assuming the bank is required to hold 10 per cent of all deposits as reserves):<\/p>\n