Endogenous or exogenous money?

While the debate on central bank monetary policy, banks and private debt (see here, here, here, here, and here) seems to have devolved into something unproductive, I have hopes that something more productive can be salvaged. These are important issues that people want to have a better understanding of. After all, we are in the middle of the worst economic calamity in most of our lifetimes. It makes sense that economists would try to gain a ‘collective’ understanding and delineate where their views diverge.

So I want to ask the real question here: is money endogenous or exogenous.

Here’s a good summation of the outstanding issues so far (and forgive me if this post is ridiculously wonkish):

  1. Do banks create money and do banks require reserves before they make a loan? Does it matter?
  2. If you are going to model an economy, do you need banks in that model; if so, is money an endogenous/dependent variable or not? Why?
  3. What can central banks control absolutely and what can they just influence? Base money stock? Credit outstanding? Overnight interest rates? Longer-term interest rates? Why?
  4. Why are most central banks now price setters instead of quantity setters i.e. rate targeters and not reserve targeters?

From what I have read, there are differeing views on most of these points. But here’s what I am seeing as the big sticking point:

I think the real difference between what Nick Rowe is saying and what people like Scott Fullwiler and Steve Keen are saying is that Nick believes over the medium-term, central bank interest rate policy is endogenous. What I think Nick means is that Scott Fullwiler’s view is reasonably clear and straightforward in his view that central monetary policy is exogenous but that it only matters over a short-term time horizon because central bank interest rate policy adjusts endogenously over the medium-term to commercial bank and other economic variables such that it is really endogenous rather than exogenous.

Further, I think Nick Rowe is saying that it creates an expectation of central bank interest rate policy merely by announcing its target rate and the market moves to accommodate that target, knowing the central bank is the monopoly supplier of reserves. In that sense the central bank has control. But what he seems to suggest is that the central bank policy rate cannot be determined independent of macroeconomic variables (like inflation specifically) and that central bank may be forced to change policy based on these, making it possible to treat the central bank policy rate as medium-term endogenous.

P.S. – Yes I have an opinion and no I don’t agree with some of the things people have been saying in this debate. But the point is not to nitpick but to come to a better understand about how the world works using economics and that’s what I’d like to see. The goal should be to keep this civil, above board and illuminating. Am I being too optimistic again?

  1. Dave Holden says

    Let me echo and applaud your P.S. sentiment, I hope you get some thoughtful replies.

  2. Nick Rowe says

    Edward: thanks. Yes, you have captured the main part of my views correctly and very clearly.

    I have some additional very non-orthodox (dare I call myself “heterodox”?) views about disequilibrium hot potato money, but it’s best to leave them out if we are trying to understand the main differences here.

  3. Jesse Frederik says

    Well played Edward. I think Keen is being utterly unproductive and narcissistic. The point of all this is not to throw insults at each other but to come to a better understanding.

    1. Edward Harrison says

      Thanks, Jesse. I just think each person has a button that you can press that causes them to go ballistic, especially if one feels someone is slagging them off unfairly. I know I have those buttons and I know exactly what some of them are.

      I regret that this has devolved but it IS an outgrowth of personalising the issues instead of sticking to the substance. Nick’s comment here shows me there really is a reason I am optimistic something will come of this.

  4. Scott Fullwiler says

    this is a good post, Ed, but this debate is muddled by a lack of definition of terms. More specifically, in the policy sciences there is a distinction made between policy, strategy, and tactics. Similar distinctions are found in business/management literature. Applying this to central banking, it goes a bit like this:

    Tactics–can the central bank directly target reserve balances, monetary base, etc?

    Strategy–what sort of rules/discretion balance does the central bank follow in adjusting the target it has set tactically. How often? How big of an adjustment each time? By what criteria?

    Policy–How does the macroeconomy work and what role can or should the central bank play in stabilizing it?

    The debate between Krugman/Keen once it got to issues related to the money multiplier and loanable funds was about tactics–can banks individually or collectively create loans without regard to deposits or reserve balances? This is closely linked to an understanding of what banks are/do and hence Krugman’s view that they didn’t need to be included since inserting them didn’t change how one should view the money multiplier or loanable funds models. This is where I jumped in, because Krugman in my view was completely wrong on these points.

    But Krugman’s reply to me, and Rowe’s post, brought in strategy and policy–“the central bank must change the interest rate target by adjusting to events and expectations” which is about how the central bank should adjust its target (strategy) within the context of how the macroeconomy works and interacts with monetary policy (policy). This is a complete tangent and obfuscation of the point that was being discussed. It is not unimportant–to the contrary, obviously—but to throw it in at this point was not helpful.

    The MMT view is that we need to understand how the tactics work to inform our strategy and even our understanding of how the economy works. Krugman tried to suggest understanding the tactics is irrelevant to these two. This is a very significant distinction between the approaches.

    Further, in MMT, we keep these three (tactics, strategy, policy) separate when we discuss them. Neoclassicals generally don’t–so, when I say the central bank must set an interest rate target (tactics) but can move that target wherever it wants (the possibilities for strategy), Nick says no the cb must set a target that responds to the economy and thus must be endogenous (strategy in the context of view of macroeconomy). We end up talking past each other as I have not invoked yet at all how central banks “should” set strategy with regard to how the macroeconomy works. While we will disagree on the latter, in our view jumping to that without clarifying and setting a common language for tactics and strategy complicates the discussion unnecessarily.

    Note finally that the “short” vs. “medium” horizon distinction Nick makes isn’t at all the same as the tactics vs. strategy distinction. The central bank can change the interest rate target every day or even every minute (possiblities for strategy) but must still defend that target every day, every hour, and every minute (tactics).

    Hope that makes some sense. And hopefully none of this is seen as a personal attack on Nick–I agree with you that Nick is one of the most stand-up guys in the blog world and one whose criticisms of my own views are to be taken seriously.


  5. Nick Rowe says

    Scott: I think I follow you on the tactics/strategy. But can you expand on that very last point please:

    “…but must still defend that [interest rate] target every day, every hour, and every minute (tactics).”

    By changing (or threatening to change) available settlement balances/reserves? Or did you have something else in mind?

    On loanable funds: my view is that if the central bank were targeting inflation perfectly (maybe absent SRAS shocks), and keeping output always at the NAIRU, the loanable funds theory of the rate of interest would be true.

    1. Scott Fullwiler says

      Hi Nick,

      “By changing (or threatening to change) available settlement balances/reserves? Or did you have something else in mind?”

      By providing the qty of balances desired by banks at whatever the target rate is at that moment. Otherwise the target will not be achieved.

      “On loanable funds: my view is that if the central bank were targeting inflation perfectly (maybe absent SRAS shocks), and keeping output always at the NAIRU, the loanable funds theory of the rate of interest would be true.”

      I would argue that it might look that way but the causation is wrong. The CB is targeting inflation via an interest rate target rule, which affects bank lending (customer desires to borrow, obviously), and then the demand for reserve balances at the target rate at any point in time, which the CB accommodates.

      The loanable funds assumes the causation is the opposite–qty of reserve balances and/or monetary base limits the operational ability of banks in the aggregate to lend and thus to create deposits.

      1. Nick Rowe says

        Hi Scott: “By providing the qty of balances desired by banks at whatever the target rate is at that moment. Otherwise the target will not be achieved.”

        OK. We are on the same page there.

        In terms of your tactics/strategy/policy distinction, what you are talking about here is a bit like a 4th category, to the left of the tactical interest rate target. Let’s call it “micro-tactics” (unless you have a better name).

        Those “micro-tactics”, plus the central bank’s conditional promises about future micro-tactics, (as communicated by its talk of tactics, strategy, and policy), are what is most “basic” in my eyes.

        The crude textbook story as I see it jumps straight from micro-tactics to strategy, skipping the intermediate step.

        Let’s leave loanable funds aside. It’s probably just a distraction.

  6. Nick Rowe says

    On causation:

    Suppose we start from the tactical perspective. The interest rate target is the exogenous variable, and (say) the inflation rate is the endogenous variable.

    Now suppose we switch to the strategic perspective. And suppose it’s an inflation target. The inflation target is now the exogenous variable, and causation now flows backwards, to the endogenous interest rate target needed to implement that strategic target.

  7. David Lazarus says

    I do think that banks should be included in any economics models. Though I do think that central banks relying solely on interest rates is a remarkably blunt weapon. I think that central banks need to watch overall debt levels even and have simple rules that can be followed by anyone. Far too often banks have said their risk model has eliminated risk, and yet Enron, WorldCom and junk MBS were AAA rated. It also allows banks to pull the wool over the regulators eyes.

  8. Marko says

    Has everyone forgotten Greenspan’s “conundrum” ? That episode showed that the Fed lost control of the most important type of lending in the period leading up to the crisis – mortgage loans.

    Despite raising the FF rate by 4% over the early-’04 to ’06 period , mortgage loan and 10-yr Treasury rates barely budged , contrary to decades worth of prior experience. They lost control of a critical loan market not for weeks , but about 2 years.

    Had mortgage rates spiked early and continued rising , as would have been expected , the housing bubble would have been short-circuited and the damage limited.

    Now , could the Fed have done more ? Probably , but both Greenspan and Bernanke seemed baffled by the episode.

    Practically speaking , however , that event comes pretty close to providing an example of ” banks creating money out of thin air “.

  9. danny says

    The current monetary system is so vague, unnecessarily complex and unaccountable. There is so much debate whether money is exogenous or endogenous…etc

    Whether banks create loans first then source reserves or not doesnt really matter IMO.
    If money is endogenous banks have too much discretion in creating money. They also have too much control over the economy because their lending creates higher demand and wages and then better lending standards to increase loans again. The banks drive the business cycles in an unstable manner.

    On the other hand if banks are reserve constrained as some argue then banks still have the final say on policy because it is the commercial banks that deal directly with the economy not the authority.

    We need to realise that either way the system is ineffective and we need to develop an economic system which isn’t dominated by bank lending but instead facilitated by bank lending.

  10. flow5 says

    “The loanable funds assumes the causation is the opposite–qty of reserve balances and/or monetary base limits the operational ability of banks in the aggregate to lend and thus to create deposits”

    The only tool at the disposal of the monetary authorities in a free capitalistic system through which the volume of money can be controlled is via legal reserves & reserve ratios.

    But in today’s world: “There is general agreement that, for almost all banks throughout the world, statutory reserve requirements are not binding” – 2006-FRBST

    Therefore the concept that the “monetary base limits the operational ability of banks in the aggregate to lend and thus to create deposits”, is an an anachronism.

    Nevertheless, Contrary to Keynes: The money supply can never be managed by any attempt to control the cost of credit.

    JUNE 1980:

    “There is no possible way for the Fed to get a “handle” on the money supply unless it has (and properly exercises) direct control over the volume of legal reserves, and the reserve ratios, of all money creating institutions. This the Act (DIDMCA of March 31st 1980), does not provide. The legal reserves of all money creating institutions should consist of directly held balances in the Federal Reserve banks – that and that alone” (like the ECB).

    This was the original definition of the legal reserves of member banks in the Federal Reserve Act of Dec. 23, 1913 – (Owens Glass Act) and it is still the only viable definition (pre-1959 requirements pertaining to assets).”

    “In due course, under this Act, our means-of-payment money supply (now designated as M1A by the Board of Governors) will approximate M-3.” THE HOUSING BUBBLE & THE GREAT RECESSION WERE NO HAPPENSTANCE.

    The first rule of reserves and reserve ratios (MONETARISM), should be to require that all money creating institutions have the same legal reserve requirements, both as to types of assets eligible for reserves, as well as the level of reserve ratios. Monetary policy should limit all reserves to balances in the Federal Reserve banks (IBDDs), and have UNIFORM reserve ratios for ALL deposits, in ALL banks, irrespective of size.

    This concept was the recommendion of the committee: Member Bank Reserve Requirements — Analysis of Committee Proposal; published — Feb, 5, 1938.

    Strangely, this research paper was DECLASSIFIED on March 23, 1983 (after the DIDMCA).

  11. Sulaiman says

    Thanks for your post Ed.

    The debate here is centered around the operational realities of the Fed (and CBs in “developed markets”) and banks in the US/DM. How does the PBOC (China) conduct its monetary policy differently (or not)? It seems to be successful in controlling credit creation through its tweeking of the RRR (quantity setting)?


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