Monday, 28 January 2013

Endogeneous Theory of Money

In this video I explore the endogenous theory of money, by explaining what it is, how it differs from exogenous theory, its historical roots and the justifications/evidence for this theory. This video is created and presented by Komilla Chadha


Endogenous Theory of Money

What is it?

  • Idea that money grows from within, from within the economy  through money demand and economic activity.

  • Money exists as needed by the real economy, because bank system reserves vary to accommodate money demand via interest rates. 

  • Banks borrow from the fed reserve discount rate as much as needed to support consumer lending and endogenous money activity .

  • This why the money is always backed by productive assets - as it is given on the basis of the real economy not depending on savings/reserves present. 

  • loans are typically created ‘out of nothing’ then central bank accommodates this response to the real economy regardless of deposits

  • Point to note; two key characteristics: (i) money backed up by productive assets and (ii) money is lent out of nothing, the loans rely on central banks lending. 

How is this different to Neoclassicism and the exogenous theory of money?

  • ‘money multiplier’ - fractional reserve system - once reserves are created then they lend out and in this process create credit 
  • Whereas, in the endogenous theory of money first loans are given out in response to money demand then does the banks accommodate the loans with borrowing from central banks.


  • Post Keynesian - so money has three functions - unit of account - measure of value, means of payment - transitionary and store of value most important which is that it is an asset in itself - an explanation for hoarding which keynes was very interested in 

  • A lot of Keynes’ monetary idea was adopted from Marx especially where the need for fiscal policy is stated 

  • Basil Moore - banks cannot control reserves in a discretionary manner - they do it on basis of the money demanded and central banks accommodate. This can be linked to the Radcliffe Report.

  • In 1957, a report chaired by Lord Radcliffe essentially said  there are two reasons why central banks have a limited role/need when it comes to stability and that is that (i) central banks can never completely control money supply as there are many near-money substitutes such as savings deposits and (ii) velocity of money cannot be controlled and has the power to alter inflation significantly. The report was completely forgot about with the creation of the Quantity Theory of Money and the rise of the monetarist.

  • The interesting thing is that now, after the Financial Crisis, questions regarding the exogeneity of money supply and therefore the role of central banks have appeared again. Moore for instance says that central banks can maybe control the supply price of money via interest rates but cannot control the quantity of credit and by implication the need for central banks extinguishes into something quite menial. 
  • Keynes argued the demand to hoard - fetish for liquidity - causes unemployment because it keeps interest rates too high to permit sufficient investment to raise ad to the full employment level .

- Tobin stresses that banks have a profit motive and are thus responsive to the private sector, so although authorities control monetary policy instruments, money supply will always be dictated endogenously by the private sector. 


  1. Does reserves come first ?- evidence shows that reserves sometimes arrive many month after money supply as increase - links to banks being responsive to economic activity as opposed to the financial sector - in neoclassical model except for inflation central banks and neutral money doesn’t have a real process 

  1. Monetarism in the 80s did reduce inflation through this monetary aggregate system - which is not possible in endogenous theory of money as it is not central banks but each agent that creates the money. In  80s banks undershot money target and interest rate - controlling money supply essentially failed. 

  1. Evidence with private debt and consumption has been shown - link to prior to recession -- this correlation is strong in the endogenous model whereas the exogenous they are just intermediaries so just redistribution of credit so not emphasis with debt and growth 

  1. For exogenous money altering the money base should have an impact on lending and other economic indictors whereas for endogenous this is ‘oiling the wheels’ minimal it is endogenous economic activity - latest qe bad results could essentially been seen as proof for endogenous theory of demand.

  1. Also if central banks can only use overnight interest rate, which only has indirect impact on quantity of reserves - as main impact is deposits - then it is clear that this set by economic endogenous activity not reserves as it is indirect .

Links to recession

When demand is low the private sector will not create money endogenously 
therefore it is the role of government and fiscal policy to increase reserves to encourage central banks to do open market operations to prevent interest rates reaching to low 0. Open market operations is not a borrowing operation why would sovereign issuer need to borrow from public - it is an interest rate mechanism. There is an issue though because the government is right now in a lot of debt so how can it fulfill this role. 

Policy Implications 

The appropriate way to control the economy is to control money demand (all three types of demand especially hoarding) and it is impossible that monetary policy affects demand, since causation runs from demand to supply not the other way round. 

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