Thoughts on Nick Rowe, Central Bank Operations, and the Money Multiplier

A new paper from the Bank of England about money creation in a modern economy has elicited a number of responses in the blogosphere over the last few days (here, here and here).  Nick Rowe has an especially clear monetarist critique of the paper.  But I think his response lays clear some of the deficiencies of market monetarism.  

Nick starts off by arguing that QE is the same thing as normal open market operations (OMOs).  I think he's right, but for the wrong reasons.  He says, in both cases, "The central bank increases the money supply by buying something.  See, it's easy!"  But it's not quite that easy.  The increase in the money supply does not come about through central bank asset purchases.  In both scenarios, the money supply increases before the central bank buys something.  Under normal operations, the money supply increases when a commercial bank originates a loan, thereby, creating a new deposit.  Only after that occurs (and not always), the central bank buys something in order to add reserves to the system to ensure that all payments clear and reserve requirements are met.  Under conditions of QE (ZIRP!), a non-bank bond holder sells a bond to a commercial bank, or a primary dealer, in exchange for a new deposit.  The bank, or primary dealer, then sells the bond to the central bank.  In both cases, the central bank buys something only after the money supply has already been increased.  Therefore, it's not accurate to claim, as Nick does, that the central bank increases the money supply.  Instead, the central bank increases the monetary base in response to an endogenous increase in the money supply.

But Nick has an answer for this:

How much money commercial banks create... depends on what the central bank is doing.

What central bank operations, exactly, do commercial banks respond to?  As we've seen, for normal OMOs and QE, the central bank always supplies whatever amount of monetary base is demanded.  So why would adjusting the monetary base beforehand make any difference?  The answer for Nick is the money multiplier.  He expresses this in three different ways:

the demand for base money is some proportion r of the stock of broad money

if the central bank wanted a temporary increase in the inflation rate, and so a permanent rise in the price level, it would need to shift the supply function of base money, to create a permanent rise in the monetary base, and a permanent rise in broad money, and the textbook money multiplier would tell us that broad money would increase by 1/r times the increase in base money.

if the central bank shifts the supply function of base money $1 to the right, that must increase the equilibrium stock of broad money by $(1/r).  

The problem is that even if you accept the first two formulations, which are consistent with my description of central bank operations, they do not entail the third, which conflicts with my description.  The first two express an ex-post mathematical relationship between the supply function of base money and the stock of broad money.  The third formulation, however, expresses an ex-ante causal relationship running from the monetary base to broad money.  In other words, while it may be true that if we want to increase the broad money supply, then we must increase the monetary base (If P, then Q), this does not mean that if we increase the monetary base (Q), then the money supply will increase (P).  Nick, and his other market monetarist compatriots, are guilty of this logical error (affirming the consequent), and because of it, have a flawed conception of money creation and, ipso facto, monetary policy.

More on helicopter money later.