Endogenous money
Encyclopedia
In economics
, endogenous money refers to the theory that money comes into existence driven by the requirements of the real economy and that banking system reserves expand or contract as needed to accommodate loan demand at prevailing interest rates. It forms part of Post-Keynesian economics. This theory is based on three main claims:
Therefore the quantity of broad money
in an economy is determined endogenously: in other words, the quantity of deposits held by the non-bank sector 'flexes' up or down according to the aggregate preferences of non-banks. Significantly, the theory states that if the non-bank sector's deposits are augmented by a policy-driven exogenous
shock (such as quantitative easing
), the sector can be expected to find ways to 'shed' most or all of the excess deposit balances by making payments to banks (comprising repayments of bank loans, or purchases of securities).
Central banks implement policy primarily through controlling short-term interest rates. The money supply then adapts to the changes in demand for reserves and credit caused by the interest rate change. The supply curve shifts to the right when financial intermediaries issue new substitutes for money, reacting to profit opportunities during the cycle. Even if the monetary authority refuses to accommodate such changes, banks can still increase reserves for loan demand through their own initiatives.
Given available credit, investment precedes and 'forces' the saving necessary to finance it. Investment determines saving rather than the converse since, in the modern world, no saving can appear without income being distributed, and no income can be distributed without entrepreneurs getting into debt. Therefore, investment plans do not need to consider savings. At times of a positive balance of payments
, banks do not retain excess reserves, either lending the excess to other banks that are running a deficit on their balance of payments, by purchasing government debt for profit. It is precisely the credit-creation process dictated by profit seeking motives that is the source of instability.
Governments and central banks, both as lender of last resort and as regulator of financial practices, help monitor the level and quality of debt, and can stop a downward profit trend, which is the key variable for debt validation and for asset prices.
Proponents deny any practical impact of the money multiplier
on lending and reserves.
, and later Joseph Schumpeter
.
, the money supply is the sum of high-powered money and demand deposits. Minsky’s financial instability hypothesis claims that this quantity is inherently unstable. His "financial instability hypothesis" starts with a high level of investment due to a high rate of profits. These profits provide cash flows to service debt which in turn yields more profits and leads to a boom in equities. Rapid output growth forces firms to take on more debt to expand production. Over time, investors come to underestimate financial risk during the boom. Eventually, interest rates surge, which forces debtors to roll once-affordable interest payments into ever-higher principal amounts. If rates remain high, more and more investments turn into "Ponzi scheme
s. Financial euphoria slowly changes to financial panic; lenders start to lose confidence in the future, asset prices decline. Eventually, borrowers can no longer refinance, gross profit eventually collapses and investment falls or even stops.
Consequently, over a period of time an economy can become susceptible to debt deflation
. To avoid deflation and a lasting depression, the central bank is expected to ‘bail out’ the financial system by providing fresh reserves to increase liquidity and reduce cost of funds. Changes in the quantity of money have a limited direct impact on the economy as a means of mitigating financial crisis. Conversely, financial crises do not depend on a rapidly increasing.
with several strands, mostly associated with the Post-Keynesian school. Multiple theory branches developed separately and are to some extent compatible (emphasizing different aspects of money), while remaining united in opposition to the New Keynesian theory of money creation.
states that the quantity of broad money is a function of the quantity of "high-powered money" or "government money"
(notes, coins and bank reserves), and the money multiplier (the inverse of the reserve ratio).
New Keynesian economists believe that when a bank has no excess reserves, new credits can only be granted if banks increase deposits, which occurs when the central bank purchases government bonds (from banks or public) on the open market, thereby changing the amount of excess reserves
. Monetary authorities can use either interest rates or the quantity of money, generally favoring the former during the Great Moderation.
They further suggest that periods of instability are short-lived and result from supply and demand "shocks". Such shocks reduce the value of existing capital stocks. They typically result from action/inaction by central banks and governments. They claim that government intervention itself commonly leads to poor capital allocation, e.g., when central banks keep real interest rates below ‘equilibrium’ rates.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, endogenous money refers to the theory that money comes into existence driven by the requirements of the real economy and that banking system reserves expand or contract as needed to accommodate loan demand at prevailing interest rates. It forms part of Post-Keynesian economics. This theory is based on three main claims:
- 'Loans create deposits': for the banking system as a whole, drawing down a bank loan by a non-bank borrower creates new deposits (and the repayment of a bank loanLoanA loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
destroys deposits). So while the quantity of bankBankA bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
loans may not equal deposits in an economy, a deposit is the logical concomitant of a loan – banks do not need to increase deposits prior to extending a loan.
- While banks can be capitalFinancial capitalFinancial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....
-constrained, in most countries a solvent bank is never reserve-constrained or funding-constrained: it can always obtain reserves or funding either from the interbank marketInterbank lending marketThe interbank lending market is a market in which banks extend loans to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the interbank rate...
or from the central bankCentral bankA central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
.
- Banks rationally pursue any profitable lending opportunities that they can identify up to the level consistent with their level of capital, treating reserve requirementReserve requirementThe reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes...
s and funding issues as matters to be addressed later – or rather, at an aggregate level.
Therefore the quantity of broad money
Broad money
In economics, broad money is a measure of the money supply that includes more than just physical money such as currency and coins . It generally includes demand deposits at commercial banks, and any monies held in easily accessible accounts...
in an economy is determined endogenously: in other words, the quantity of deposits held by the non-bank sector 'flexes' up or down according to the aggregate preferences of non-banks. Significantly, the theory states that if the non-bank sector's deposits are augmented by a policy-driven exogenous
Exogenous
Exogenous refers to an action or object coming from outside a system. It is the opposite of endogenous, something generated from within the system....
shock (such as quantitative easing
Quantitative easing
Quantitative easing is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank buys financial assets to inject a pre-determined quantity of money into the economy...
), the sector can be expected to find ways to 'shed' most or all of the excess deposit balances by making payments to banks (comprising repayments of bank loans, or purchases of securities).
Central banks implement policy primarily through controlling short-term interest rates. The money supply then adapts to the changes in demand for reserves and credit caused by the interest rate change. The supply curve shifts to the right when financial intermediaries issue new substitutes for money, reacting to profit opportunities during the cycle. Even if the monetary authority refuses to accommodate such changes, banks can still increase reserves for loan demand through their own initiatives.
Given available credit, investment precedes and 'forces' the saving necessary to finance it. Investment determines saving rather than the converse since, in the modern world, no saving can appear without income being distributed, and no income can be distributed without entrepreneurs getting into debt. Therefore, investment plans do not need to consider savings. At times of a positive balance of payments
Balance of payments
Balance of payments accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers...
, banks do not retain excess reserves, either lending the excess to other banks that are running a deficit on their balance of payments, by purchasing government debt for profit. It is precisely the credit-creation process dictated by profit seeking motives that is the source of instability.
Governments and central banks, both as lender of last resort and as regulator of financial practices, help monitor the level and quality of debt, and can stop a downward profit trend, which is the key variable for debt validation and for asset prices.
Proponents deny any practical impact of the money multiplier
Money multiplier
In monetary economics, a money multiplier is one of various closely related ratios of commercial bank money to central bank money under a fractional-reserve banking system. Most often, it measures the maximum amount of commercial bank money that can be created by a given unit of central bank money...
on lending and reserves.
History
Theories of endogenous money date to the 19th century, by Knut WicksellKnut Wicksell
Johan Gustaf Knut Wicksell was a leading Swedish economist of the Stockholm school. His economic contributions would influence both the Keynesian and Austrian schools of economic thought....
, and later Joseph Schumpeter
Joseph Schumpeter
Joseph Alois Schumpeter was an Austrian-Hungarian-American economist and political scientist. He popularized the term "creative destruction" in economics.-Life:...
.
Financial instability hypothesis
According to Hyman MinskyHyman Minsky
Hyman Philip Minsky was an American economist and professor of economics at Washington University in St. Louis. His research attempted to provide an understanding and explanation of the characteristics of financial crises...
, the money supply is the sum of high-powered money and demand deposits. Minsky’s financial instability hypothesis claims that this quantity is inherently unstable. His "financial instability hypothesis" starts with a high level of investment due to a high rate of profits. These profits provide cash flows to service debt which in turn yields more profits and leads to a boom in equities. Rapid output growth forces firms to take on more debt to expand production. Over time, investors come to underestimate financial risk during the boom. Eventually, interest rates surge, which forces debtors to roll once-affordable interest payments into ever-higher principal amounts. If rates remain high, more and more investments turn into "Ponzi scheme
Ponzi scheme
A Ponzi scheme is a fraudulent investment operation that pays returns to its investors from their own money or the money paid by subsequent investors, rather than from any actual profit earned by the individual or organization running the operation...
s. Financial euphoria slowly changes to financial panic; lenders start to lose confidence in the future, asset prices decline. Eventually, borrowers can no longer refinance, gross profit eventually collapses and investment falls or even stops.
Consequently, over a period of time an economy can become susceptible to debt deflation
Debt deflation
Debt deflation is a theory of economic cycles, which holds that recessions and depressions are due to the overall level of debt shrinking : the credit cycle is the cause of the economic cycle....
. To avoid deflation and a lasting depression, the central bank is expected to ‘bail out’ the financial system by providing fresh reserves to increase liquidity and reduce cost of funds. Changes in the quantity of money have a limited direct impact on the economy as a means of mitigating financial crisis. Conversely, financial crises do not depend on a rapidly increasing.
Branches
Endogenous money is a heterodox economic theoryHeterodox economics
"Heterodox economics" refers to approaches or to schools of economic thought that are considered outside of "mainstream economics". Mainstream economists sometimes assert that it has little or no influence on the vast majority of academic economists in the English speaking world. "Mainstream...
with several strands, mostly associated with the Post-Keynesian school. Multiple theory branches developed separately and are to some extent compatible (emphasizing different aspects of money), while remaining united in opposition to the New Keynesian theory of money creation.
- ChartalismChartalismChartalism is a descriptive economic theory that details the procedures and consequences of using government-issued tokens as the unit of money. The name derives from the Latin charta, in the sense of a token or ticket...
emphasizes fiat moneyFiat moneyFiat money is money that has value only because of government regulation or law. The term derives from the Latin fiat, meaning "let it be done", as such money is established by government decree. Where fiat money is used as currency, the term fiat currency is used.Fiat money originated in 11th...
creation by governments, which they argue is by deficit spendingDeficit spendingDeficit spending is the amount by which a government, private company, or individual's spending exceeds income over a particular period of time, also called simply "deficit," or "budget deficit," the opposite of budget surplus....
. - Monetary circuit theoryMonetary circuit theoryMonetary circuit theory is a heterodox theory of monetary economics, particularly money creation, often associated with the post-Keynesian school....
was developed in France and Italy, and emphasizes credit money creation by banks. - In America, Basil MooreBasil Moore (economist)Basil Moore is a Canadian Post-Keynesian economist, most known for developing and promoting endogenous money theory, particularly the proposition that the money supply curve is horizontal, rather than upward sloping, a proposition known as horizontalism...
was the main driver in the 1970s and 1980s, emphasizing credit money creation by banks.
Exogenous theories of money
Mainstream (New Keynesian) economic theoryMainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...
states that the quantity of broad money is a function of the quantity of "high-powered money" or "government money"
Monetary base
In economics, the monetary base is a term relating to the money supply , the amount of money in the economy...
(notes, coins and bank reserves), and the money multiplier (the inverse of the reserve ratio).
New Keynesian economists believe that when a bank has no excess reserves, new credits can only be granted if banks increase deposits, which occurs when the central bank purchases government bonds (from banks or public) on the open market, thereby changing the amount of excess reserves
Excess reserves
In banking, excess reserves are bank reserves in excess of the reserve requirement set by a central bank. They are reserves of cash more than the required amounts. Holding excess reserves is generally considered costly and uneconomical as no interest is earned on the excess amount...
. Monetary authorities can use either interest rates or the quantity of money, generally favoring the former during the Great Moderation.
They further suggest that periods of instability are short-lived and result from supply and demand "shocks". Such shocks reduce the value of existing capital stocks. They typically result from action/inaction by central banks and governments. They claim that government intervention itself commonly leads to poor capital allocation, e.g., when central banks keep real interest rates below ‘equilibrium’ rates.
| Endogenous | Exogenous | |
|---|---|---|
| Quantity of money | Endogenous | Endogenous or exogenous |
| Policy tool | Interest rates | Interest rates (including on excess reserves), open market operations, expectations |
| Causality | Investment drives money | Savings/quantity of money and expectations can drive rates |
| Money multiplier | Irrelevant | Relevant |
| Stabilization | Government-led | Market-led |