Endogenous Money

Endogenous money is the view that the supply of money is determined within the economic system, by the demand for credit and by the lending decisions of banks, rather than being set exogenously by the central bank. The view is associated with post-Keynesian economics and with the analysis of the banking system.

The Concept

The endogenous money view holds that banks create money when they extend credit, and that the amount of money in circulation is therefore determined by the demand for loans and by the willingness of banks to lend. The central bank influences the process by setting the price of reserves, but it does not directly control the quantity of money.

The view contrasts with the exogenous money view, in which the central bank controls the money supply and banks intermediate existing funds. Under the exogenous view, the central bank sets the quantity of money, and the banking system adjusts to it.

The Money Multiplier

The textbook analysis of money creation relies on the money multiplier, in which the central bank sets the quantity of reserves and the banking system expands deposits by a multiple of the reserves. The multiplier is derived from the reserve requirement and from the behaviour of the public in holding currency.

Critics of the multiplier argue that it reverses the direction of causation. In their view, banks lend first, creating deposits, and then seek the reserves needed to settle the transactions. The central bank accommodates the demand for reserves, so that the quantity of reserves is determined by the lending decisions of banks rather than the other way around.

Empirical evidence supports the view that lending drives deposits, at least in modern financial systems where reserve requirements are low and where central banks target interest rates rather than quantities.

Implications for Policy

The endogenous money view has implications for monetary policy. If the central bank cannot control the quantity of money directly, it must operate by setting the price of reserves and by influencing the demand for credit through interest rates.

The view also has implications for the analysis of inflation. If money is created by bank lending, then inflation is driven by the demand for credit and by the factors that influence it, rather than by an exogenous increase in the money supply.

The view is relevant to the analysis of financial stability, since the creation of credit by banks is central to the build-up of leverage and to the emergence of financial fragility. It supports the use of macroprudential instruments to contain credit growth.

Debate

The endogenous money view is contested. Critics argue that the central bank retains substantial control over the money supply, particularly in systems with reserve requirements and with a monopoly on the creation of base money. They argue that the central bank can constrain the expansion of credit if it chooses.

The debate is partly about the institutional arrangements of different monetary systems and partly about the appropriate level of abstraction. In systems where the central bank targets interest rates and supplies reserves on demand, the endogenous view describes the process more accurately; in systems where the central bank controls quantities, the exogenous view may be more appropriate.

The Post-Keynesian Tradition

The endogenous money view is associated with post-Keynesian economics, which emphasises the role of uncertainty, of institutions, and of historical time in economic analysis. Post-Keynesians argue that money is created by the banking system in response to the demand for credit, and that the central bank accommodates that demand.

The tradition draws on the work of Keynes and of his followers, and it has been developed by economists including Nicholas Kaldor and Basil Moore. It emphasises the role of banks as creators of credit, and it rejects the view that banks merely intermediate existing savings.

The post-Keynesian analysis of money has implications for the analysis of inflation, of financial instability, and of the conduct of monetary policy. It supports the view that inflation is driven by the conflict over income shares and by the availability of credit, rather than by the growth of the money supply.

Horizontalism and Structuralism

Within the post-Keynesian tradition, two approaches to endogenous money are distinguished. Horizontalists hold that the central bank accommodates the demand for reserves fully, so that the supply of reserves is perfectly elastic at the policy rate. The money supply is then determined entirely by the demand for credit.

Structuralists hold that the central bank accommodates the demand for reserves only partially, and that the response depends on the stance of policy and on the state of the economy. The money supply is then determined by both the demand for credit and the response of the central bank.

The distinction matters for the analysis of the effectiveness of monetary policy. Under horizontalism, the central bank influences lending only through the interest rate. Under structuralism, the central bank can also influence lending through the quantity of reserves, and it can use credit controls and other instruments.

Financial Instability

The endogenous money view is connected to the analysis of financial instability. Hyman Minsky argued that the creation of credit during periods of optimism leads to the build-up of leverage and to the emergence of financial fragility, which eventually culminates in a crisis.

The Minsky analysis emphasises the procyclical behaviour of banks, which lend more freely during booms and restrict credit during downturns. The behaviour amplifies the cycle and creates the conditions for instability.

The analysis has implications for policy. It supports the use of macroprudential instruments to contain the growth of credit during booms, and it supports the use of the central bank's balance sheet to support credit during downturns. It also supports the view that monetary policy should consider financial stability alongside inflation.

Summary

The endogenous money view holds that the money supply is determined by the demand for credit and by the behaviour of banks, and it has implications for the analysis of monetary policy and of financial stability. Its development within the post-Keynesian tradition has shaped the debate about the nature of money and of banking.

See also

• Monetary Economics
• Money Market
• Lender of Last Resort