The money multiplier is a theory on the link between the quantity of base money (central bank reserves) to the quantity of broad money (bank deposits, currency) in the financial system. In this theory, the central bank adjusts the level of base money in the system, which gives commercial banks greater room under their reserve ratios to lend, which then increases the quantity of broad money. This sounds reasonable, but is inaccurate because commercial banks (and the banking system as a whole) are never constrained by reserves in their lending – they can always borrow more reserves, manage their liabilities differently, or evade regulations by moving their activity off-shore. In this post I’ll show why there is no such thing as a money multiplier.
In this series I will talk about dead macro concepts that refuse to die. Today’s installment of Zombie Concepts features the velocity of money – a concept often discussed but easily shown to be useless. I will draw heavily from a excellent recent IMF paper on the subject by central banking expert Peter Stella et al. Basically, the velocity of money is a useless concept because it is not stable nor mean reverting. It cannot be used to link money supply to GDP. It is not stable because 1) its measurement does not include transactions that do not contribute to GDP, and 2) it’s affect by technological changes. There is no justification in thinking that velocity will eventually rises, leading to higher GDP growth on account of the larger M2 money stock.