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

Transcript

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.

History?

• 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. 

Evidence/Justifications 

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. 

“Asset Allocation with Inflation-Protected Bonds." Kothari & Shanken

Kothari S. P. and J. Shanken, “Asset Allocation with Inflation-Protected Bonds.”,Financial Analyst Journal, Charlottesville, Jan/Feb 2004, Vol.60, Iss.1, p.54

Essentially they show that both indexed and non-indexed stocks and bonds should be kept for portfolio optimization. 

Key Points:

• Returns on indexed bonds are less volatile than non-indexed bonds

• The correlation between the returns on indexed stocks and non indexed stocks, appears to be zero, as opposed to the internal relationship of non-indexed securities to be 0.4. This is important as it provides scope for portfolio diversification.

• Conventional bond yields (non-indexed) contain a positive premium for the inflation risk they carry. Research, however,  says that this yields have not provided the positive premium in recent years.

• Indexed bond market is less liquid and thus is attractive for long-term investors and has potential to increase yields. 

• “...the results suggest that substantial weight should be given to indexed bonds in an efficient portfolio. We do not recommend that an investor’s actual asset allocation be based solely on observations of thus sort, but the results certainly have affected our beliefs about the potential benefits of indexed bonds.” p67 

• Speculation of the future yield spread for the indexed bonds is more difficult, but as suggested above if the inflation risk premium on conventional bonds has been too low then this should increase attraction for indexed bonds and stocks. 

Why do we have central banks?

Why do we have central banks?

Why do nations have central banks? And if they do not, why are they pressurised to have one? The answer lies in their function to stabilise prices and maintain full employment by monetary policy. This post will expound of the function of the central banks in inflation targeting, being a ‘lender of last resort’ and ensuring financial stability. These are the three crucial reasons why countries have central banks. Before concluding, a brief look at the Radcliffe Report will be made in order for us to really get down to whether the existence of a central bank is in fact as necessary as we make it out to be.

Inflation Targeting

It is accepted that it is the role of central banks to target inflation and achieve full employment synonymously through one unified monetary policy. However, in this post I want to focus mainly on inflation targeting, as the specificity with which the goal is carried out implies that it a goal of higher priority than full employment. 

According to mainstream economic theory, money is endogenous and thus has the ability to be controlled by an external agent such as the central bank. By controlling the money supply, inflation can be easily targeted. This is simply explained through Fisher’s Quantity Theory of Money which states that the velocity of money is constant in the long-run and national income is fairly predictable therefore according to the formula MV = PY, money supply is equal to the price level. 

By manipulating interest rates, you determine how much money is spent in the economy and how much is saved. Open Market Operation, too alter the amount of money held by the central bank, instead of the amount held by the public. So it fairly obvious then  that central banks can do this. This was very much believed to be the cure to inflation in the 1970s and influenced important economic events such as the Thatcher experiment. 

Then, why does the central bank need to be involved, surely the government could carry this task out? What happened in reality is that governments manipulated interest rates in political cycles, loosening monetary policy when election time drew close. Thus, by having an independent central bank with the sole goal of inflation targeting, short-political cycles would not form and inflation would be under control.

Central banks, that inflation target as a priority have a very specific criteria that they follow. For instance, they have an established numerical target like the Bank of England has of 2% and our transparent about the mechanism they use to achieve this goal. It is clear then that the Fed for instance could not be said to be inflation targeting in the strict sense, so what are some of the other reasons for having a central bank?

“Lender of Last Resort”

Central banks are deemed to be lenders of last resort, but what does this mean? This means that when liquidity dries and there is no credit being lent as seen in the Financial Crisis of 2008, it is the responsibility of the central bank to lend money and stimulate the credit market. This was based on the economic theory that banks should act as if no central bank existed in boom times and in bust the central bank would aid the economy. Thus we need central banks. In the Financial Crisis of 2008, the accumulation of ‘bad debt’sucked the credit out of the money market, had it not been of the central banks and their manipulation of quantitative easing, we would be in a worse position than we are today, so the theory goes. 

However, as mentioned before it was ‘bad debt’ which dried the credit market, debt which essentially cannot be paid so how will central banks lend non-existent money? They sell government bonds, however, this lends to an increase in money supply and pushes up inflation. Already we can see clash in the functions of the bank. The point to note for this post is that without a central bank, these problems could not be solved, so the theory states. 

Financial Stability

After the wake of the Financial crisis there has been a lot of talk on the role of the central bank as the banking supervisor, without whom we will not be able to avoid another financial crisis. This is because the central bank supervises commercial banks and ensures that all banking practises is sustainable. 

Financial stability links very closely to the need of central banks in inflation targeting. Political monetary cycles as discussed before cause instability and that is what gave birth to idea of an external institution, a central bank in stability. Conventional wisdom is that leaving the money market to the invisible hand of supply and demand is ineffective and too dangerous and thus the need for central banks. 

In the banking sector particularly, information asymmetry is a problem, as Goodhart points out consumers just don’t know the difference between banks. Therefore, some kind of security and buffer cushion like a central bank - a lender of last resort- becomes even more crucial in creating stability and given consumers and investors confidence. 

Central banks usually help create financial stability by setting reserve requirements too which are minimum requirements of deposits that banks have to keep as reserves. Commercial banks are profit-maximising enterprises and reserves make no return what so ever. Returns come from lending money in various forms so banks will want to keep reserves as low as possible so having a central bank which sets reserve requirement particularly helps in taming commercial bank drive for profit. 

Moreover, central banks also ask commercial banks for bank balance details etc and create ratios which they can pass to the Financial Services Authority for checking and monitoring.

Radcliffe Report

Before concluding, it is important to look into the Radcliffe Report. All the purposes and need for central banks highlight above rest on the assumption that money is exogenous and thus can be controlled. However, in 1957, a report chaired by Lord Radcliffe argued something else. The report 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 exogenous 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. 

Conclusion

In sum, the need for a central banks relates to stability in the economy, whether it is price stability, financial stability or liquidity stability in downturns. However, the Financial Crisis 2008, has drawn some light into whether this is really a need and whether central banks are actually effective at what they do. The key problems with them can be drawn back to the Radcliffe Report of 1957.

Commercial Bank Operations (Notes)

Lewis, MK and Davis, KT, 1987, Domestic and International Banking, Hemel Hempstead: Plillip Allan, ch. 2, 

Chapter 2: Financial Intermediaries and Financial Assets

2.1 Intermediaries Services: An Introduction

• Essentially comes down to offering some financial product e.g. loans, and means to invest with deposits

• Intermediation services: require an act of joint consumption by the loan and deposits customers. It is contracts with the provision of services arising from differences in the characteristics of contracts entered into depositors and borrowers

• Two types of intermediation: (i) ‘distributive’ or ‘brokerage’ - facilitate the transfer of ownership of existing financial assets, while doing this they supply information/specialist advice yet do not alter the characteristic of the financial asset and (ii) More often however, what is done is that the primary securities (those offered by the borrowers) is altered to the secondary securities (offered by the financial intermediary) and the way this is done is by issuing different contracts.

 We can spilt the types of financial products offered in three categories:

1. Payment services - providing money to pay for goods/services
2. Consumption transfer - where firms can invest now and consumers can pay over time
3. Financial security - ensures the continuance of consumption and investment in the face of a change in economic circumstances, ill health, accidents etc.

2.2 Stages of Intermediation

• This section look at hypothetical states to illustrate the need for financial intermediaries.

1. Absence of Financial Assets - Initially we need money to overcome the inefficiencies and economic costs of barter exchange. It also allows people to invest as they have previously accumulated money balances.

1. Direct Financing - By allowing for borrowing and lending, the constraints upon savings and investment can be more comprehensively lifted. Lenders are encouraged to save as before they could save only in 2 ways: hold on to commodity, whose liquidity and value is not certain or clear or hold onto money which has a certain monetary value yet bares no interest, so financial assets offer a middle choice. For direct financing to occur, borrowers and lenders with common interest need to meet this can either happen by accident or there will be transition cost involved. So by paying an interest rate which is acceptable they eradicate the transaction cost. Two types of problems arise when there is a separation of savings from the accumulation of wealth (i) ex ante problem of imperfect information where the lender cannot get full information of the borrowers and adverse selection where asymmetric information costs arise because of the lender’s inability to observe the attributes of the borrowers and (ii) ex poste problem which is that there is a moral hazard that many borrowers flow because of the inability of lenders

1. Information Services of Intermediaries - Creating a pool of data on investors and borrowers and so providing information quite easily. They can offer specialist advice to customers based on the information they have accumulated.

1. Portfolio Transformation Services - Where the borrowers and investors do not match in size, duration or in any other respect, intermediaries match it by ‘debt substitution’ that is the substitution of the intermediaries own liabilities for those of the ultimate borrowers. Two levels of this are: (i) contract level  - the process of gathering information and monitoring teh investments is also centralized, but in addition to reducing transition costs, this substitution alters the pattern of claims and thus reduces the risk to lenders, if only by the means of the pooling process. (ii) issuing contracts to lenders which are fundamentally different to those issued to borrower, this closes the problem with the gap between lenders and borrowers and this can be done by attaining specialist information. Instead of distributing the liquidity as with the first level, here the ‘creation of liquidity’ happens and this means that where borrowers assets acquired by the intermediary are information and incentive sensitive, they are converted into liquid claims from the viewpoint of lenders.

1. Liquidity production: Intermediaries usually ‘impart liquidity’ and what this means is that the primary securities they attain are usually less liquid than the secondary securities they offer. Liquidity is based on the asset’s marketability, reversibility, divisibility and capital certainty. (1) Marketability realated to the ease and speed within which the value of the asset can be realised. (2) Reversibility refers to the discrpency in value between the contemporeous acquisition and realisation of an asset (3) Divisibility is reflected in the smallest unit in which transactions in the asset concerned can occur. And (4) Capital certainity is the extent to which an asset’s future value in terms of cash can be predicted at future dates. Liquidity is not real science, it is more subjective and it based on teh intermediaries perception of the asset can be defined as having high amounts of these four characteristics.

The Rationale for Intermediaries: A summary

The complete markets paradigm

• Arrow-Debreu general equilibrium model, basically that AD=AS
• There is basically a market failure in a situation where financial intemediaries do not exist, that is they reduce search, monitoring and transaction costs and provide savers with greater safety and financial security than they can obtain from their own portfolios without access to makrets for contingent claims. 
• Orginally it was understood that financial intemediaries represent the final stage in the evolution of the financial system and now the new view is that it should be seen no more than transitory phase in the evolution path to a full set of Arrow-Debreu markets. 

2.3 Pooled Investment Funds

• Both mutual funds, or open ended investment companies (US name), and unit trusts (UK name) are legal constructions which permit the ‘pooling of a large number of small unequal amounts of money belonging to different induviduals in a common fund to be invested by skilled managers’. 
• Open-ended and close-ended are both funds of pooled investment the difference is in how they both are managed. Open-ended fund issues and redeems shares on demand, whenever investors put money in or out the fund. The close-end fund is a different animal. Like a company, it issues a set number of shares in an initial public offering and they trade on an exchange.
• The point of these is to create a size sufficiently large for risk diversification to operate.
• The three functions of open-ended pools which allow induviduals to purchase a share of managed portfolio:

1. ‘Brokerage’ - information is processed and collected for resale
2. ‘Diversification’ - As the fund is large it allows risk to be diversified
3. ‘Liquidity’ - units can be readily encashed, and open-ended funds are more liquid than direct shareholdings.

2.4 Money Market Mutual Funds

• Whereas mutual funds had their origins in Britain in 19th C & were well estabilished in the US by the 1930s, money market mutual funds are of very recent origin.
• The pooled funds for Money markets is placed mainly on short-term ‘prime’ paper. This paper is only issued in large denominations e.g. $1 mil minimum and without pooling the investment would clearly be beyond the resource of most induviduals. Thus the funds untertake a size intermediation , enabling induviduals to aggregate their resources in order to take advantage of the higher interest rate avaliable on large job lots.
• Also very low risk and examples include: t-bills, CDs, Broker’s Call, Federal funds. Essentially what we have to remember is that money market securities are low risk and low return.
• http://www.investopedia.com/articles/mutualfund/04/081104.asp#axzz290qnaunV 

2.5 Savings Institutions 

• Common elements in savings instituitions: 

1. most liabilities take the form of deposits whereby gathering of funds is facilitated and the attractiveness of the liabilities enhanced, by the ability of customers to make small-scale deposits and withdrawals upon savings account with the intermediary.
2. No depositer has an account which could be regarded as of significant size relative to intemediary’s total deposit liability.
3. The asset portfolio is on average of longer maturity than the liability portfolio
4. The asset portfolio contains a reserve of highly liquid assets 
5. Thos earning assets mostly consist of a large number of small claims on different households or firms which in most cases are induvidually not marketable.

• They are different to mutual funds in two regards (i) the savings institutions may be able to get a spillover effect from their deposit business to their loan portfolio and (ii) in the course of monitoring the deposit business of customers, the instiutions build up a profile as to a customer’s ability to repay loans. 

2.6 Insurance Institutions 

• Insurance companies take in funds, called premiums, invest them in securities to generate investment income, and then pay out to policy-holders.

Life Insurance

• For term policies the insurer holds prepaid premiums on behalf of those insured. With whole-life policies the same principle applies, but on a larger scale. Endowment insurance policies require the insurer to manage an accumulating balance of the insured’s savings. Annuities require the insurer to manage a decumulating balance of the annuitants’ savings. 

General Insurance

• General insurers are in no sense savings institutions or providers of other forms of wealth accumulation. But the basis of almost all insurance is the accumulation of a fund of assets from which uncertain losses can be met.

Maturity Transformations

• This relates to the function of commercial banks above which is to create liquidity and take risks upon itself (which isn’t as irrational as it sounds given that they should have less risk as they have information and specialist knowledge).
• They buy assets which are long and small in size and they transform them into short-term larger securities.
• The issue is still how is it logical for banks to give liquidity guarantees which don’t exist and guarantees of deposit which as with the nature of any security they use the deposit for, cannot actually exist.

Four Major concerns for bankers while profit-maximizing

1. Liquidity Managements : Reserves in banks earn zero interest especially as the law says there are no reserve requirements in UK or USA. So the concern is how many liquid assets such as T-bills to keep in reserves for when there is an emergency yet profit maximize as much as possible.
2. Asset Management: Loans are asset and default risk is absolutely crucial as banks have to make that up elsewhere because it is depositors money not their own money they use to give out loans. So the issue is how can you essentially get that idea low risk high return which doesn’t necessarily exist.
3. Liability Management : Liabilities are deposits and bankers are searching low cost ways to increase liabilities. They do this by offering deposit insurance to a certain extent, but again they are constantly questing are there cheaper ways to attract funds.
4. Capital Adaquency Management : Similar to liquidity management, where that was focused on the nature of reserves that banks keep capital adaquency questions the size question, how much capital should exist in reserves.

Trends in the realms of Banking and Finance

1. Merger & Acquisition - The trend that investment banks are merging with commercial banks and the motivation behind this is that the nature of mergers reduce costs thus providing incentives for shareholders to vote for it.
2. Executive Pay - Incentives for board members to get bonuses by getting involved with risk strategy issues and mis calculating risk as a result.
3. Capital Adquency Management -Banks are not keeping enough capital, in some cases they are so blinded by the risk calculation they lend 167% of capital to just one borrower. There are new regulations coming now. 
4. Growing Competition - Competition and new ways of banking are changing the face of banking. For example the surge in internet banking and  the enormous cost incentives has resulted in the closure in many bank branches, leaving the few banks remaining with merely operational staff.

Banking&Finance: Introduction to Financial Markets& Intermediaries

In this video I explore the who, what, why and how of financial markets and intermediaries.