Economics textbook vs Bank of England

I blogged yesterday about this recent paper on money published by the Bank of England. The paper outlines the process by which banks create money and states a number of times that the reality differs from how most economics textbooks treat the subject. From time to time, when mainstream economics is challenged in this way, its defenders respond by saying one of the following things:

1. We already know that;

2. It’s not true that the textbooks teach in that (inaccurate) way;

3. The textbook version is just a simplification for new students, and more advanced courses teach the right way.

I thought I’d very quickly tackle points 2 and 3 by digging out my old undergrad textbook. The text we used was ‘Macroeconomics (5th Edition)’ by N. Gregory Mankiw. This was purchased in 2002 for the princely sum of £34.99,  but I believe this (updated) text remains the best selling macro textbook.

Very briefly then. The BoE paper writes:

“The reality of how money is created today differs from the description found in some economics textbooks”

Like what? The paper asserts:

• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.

While the Mankiw textbook (p485) says:

“…financial markets have the important function of transferring the economy’s resources from those households that wish to save some of their income for the future to those households and firms that wish to borrow to buy in investment goods to be used in future production. The process of transferring funds from savers to borrowers is called financial intermediation.”

Back to the BoE:

“One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them.”

BoE again:

• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.

Mankiw (p487):

“Each dollar of the monetary base produces m dollars of money.  Because the monetary base has a multiplied effect on the money supply, the monetary base is sometimes called high-powered money.”

So it’s clear there are things in mainstream texts that would seem to be wrong or misleading, contrary to point 2 above, but is point 3 correct? Is it all just a necessary simplification as a starting point for learning complex ideas? While Mankiw does talk of ‘models’ it doesn’t say that the model does not really reflect reality and is just a simplification, and I studied economics to Masters level without being disabused of these ideas. It was only relatively recently I discovered these textbook example was not necessarily the truth. That could be a personal failing on my part, but I suspect I am not alone.





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