What's wrong with the money multiplier? - Banking 101 (Part 2 of 6)

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There's a lot of confusion about how banks work and where money comes from. Very few members of the public really understand it. Economics graduates have a slightly better idea, but many university economics courses still teach a model of banking that hasn't applied to the real world for decades.

In this video course we'll discover how banks really work, and how money is created.

In this we'll look at:

WHAT'S WRONG WITH THE TEXTBOOK MULTIPLIER MODEL?

Most of the economics or finance students and graduates get taught about something called the 'money multiplier'. The money multiplier story says that banks actually create much of the money in the economy.

The fact is that the multiplier model that is still taught in many universities is completely wrong. It's an inaccurate and outdated way of describing how the banking system works. In fact, banks in the UK haven't worked like this for years.

The fact that this model is still used is a problem for three reasons:

- Firstly, this model implies that banks have to wait until someone puts money into a bank before they can start making loans.

- Secondly, it implies that the central bank has ultimate control over the total amount of money in the economy.

- But the most significant implication of this model is that the Bank of England, or the Federal Reserve or European Central Bank, has complete control over how much money there really is in the economy, so there's absolutely no possibility that the money supply can get out of control.

There's just one small problem. Almost everything about this description of banking is wrong.

In fact, Professor Charles Goodhart, of the London School of Economics and an advisor to the Bank of England for over 30 years, described this model as "such an incomplete way of describing the process of the determination of the stock of money that it amounts to mis-instruction."

Sources: [Lombra, http://www.jstor.org/pss/40325454]

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Positive Money is a not-for-profit research and campaign group. They work to raise awareness of the connections between our current monetary and banking system and the serious social, economic and ecological problems that face the UK and the world today. In particular they focus on the role of banks in creating the nation's money supply through the accounting process they use when they make loans - an aspect of banking which is poorly understood. Positive Money believe these fundamental flaws are at the root of - or a major contributor to - problems of poverty, excessive debt, growing inequality and environmental degradation. For more information, please visit: http://www.positivemoney.org/

Animation by Henry Edmonds

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