...against fictions and other tall tales

Sunday, 30 September 2012

Thoughts on endogenous money

The author of Unlearning Economics has written two good posts on the endogenous nature of money (i.e., the notion that the money supply adjusts to the demand for money). I agree with the author's assertion that recognizing the endogenous nature of money is important in order for policymakers to properly address issues relating to financial instability.

Just to add to this discussion, the key aspect about the endogenous nature of money is its ambivalent effects on the working of the economic system. On the one hand, as stressed by many post-Keynesian monetary economists (especially circuitistes and modern monetary theorists), the endogeneity of money enables both the level of investment and growth to surpass what it would otherwise be in a context of self-financing.

According to this view, a recognition of the endogeneity of money frees us from the "fictitious" constraint of a fixed money stock and, as such, opens up new possibilities (from a economic policy standpoint) for achieving full employment and improved living standards (e.g., via public investment financed by government deficit financing and money creation). Also, it forces us to look for a better explanation in regard to the causes of inflation and to reconsider the popular view that inflation occurs solely as the result of an excessive rate of growth in the money supply or as a consequence of government deficit spending. In a context of endogenous money, the causality between increases in prices and the money supply can also be considered as flowing from prices and output to money rather than uniquely the other way around, as is most often believed.

On the other hand, as recently emphasized by the staff economist of the Bank for International Settlements (BIS), the endogenous nature of money, by allowing investment to surpass the capacity of self-financing, also acts to intensify the inherent risks and instability of the modern economy (in which finance plays a critical role) by creating the conditions that lead to unsustainable booms in credit and asset prices that "can eventually lead to serious financial strains and derail the world economy" (Borio and Disyatat, 2011:27).

Now, let me be clear: I'm not saying that these approaches are irreconcilable, or that they exclude each other's views on the issue. On the contrary, one has to look very closely to uncover the difference between the views on the monetary system of post-Keynesian monetary economists and those of BIS economists. They are quite similar in many respects, as recently highlighted by economist Bill Mitchell. For instance, recall that the late Hy Minsky, a post-Keynesian economist, emphasized long ago the destabilizing effect of the modern financial system, a notion that is closely aligned with the views of the BIS economists today. So, in this sense, all I mean to suggest is that the focus of these two groups of economists tends to be different, not that both views are necessarily different in scope.* (For instance, modern monetary economists have been doing some excellent work to address the financial stability issue. See, for instance, Randall Wray and Eric Tymoigne.)

Finally, I will just conclude by saying that, in Canada (where I reside), empirical evidence pointing to the endogeneity of money (i.e., that money supplied by the central bank is demand-led) has been around for a while. Consider this excerpt from Bank of Canada Technical Report 16: Monetary Base and Money Stock in Canada by economists Kevin Clinton and Kevin Lynch arguing against the notion of an exogenous money supply:
...the findings contrary to the monetarist position are strongly enhanced by evidence that emphatically demonstrates causality running from money to the base. The historical association observed between the two arises primarily from the influence of deposits on bank reserves, not vice versa, so that the existing correlation, weak though it may be, could give an exaggerated impression of how well the money supply could be controlled via the base. [...] The empirical tests reject the notion that there is "direct" link between bank reserves and bank deposits and that changes in bank reserves cause changes in bank deposits. (4,40)
This technical report was published in 1979. I know of no convincing evidence that refutes these findings (keeping in mind that Canada no longer requires banks to hold reserves).

* The difference between the two approaches lies mainly in their views regarding the existence of the Wicksellian notion of natural rate of interest. Although this is not an insignificant issue, for the purpose of this post there is no need to elaborate further on this point.


Borio, C., and P. Disyatat, Global imbalances and the financial crisis: Link or no link? Bank for International Settlements Working Paper No. 346, May 2011.

Clinton, K. and K. Lynch, Bank of Canada Technical Report 16: Monetary Base and Money Stock in Canada, Bank of Canada, 1979


  1. Rural Development Guy1 October 2012 at 17:10

    Great stuff. I believe (I may be wrong) that this point was not taken up by the leading anti-monetarist authors of the era. For instance, Peters' and Donner's "The Monetarist Counter-revolution: A Critique of Canadian Monetary Policy, 1975-1979", as I recall it, published the same year as the technical report, detailed many failings of Canadian monetarist attempts to control monetary aggregates, and debunked many of the monetarist arguments regarding inflation, but did not include mention of these findings. I wish I had identified that BoC technical report when I was writing my Master's thesis!

    1. @Rural Actually, the BoC has done quite a good job of targeting 2% inflation for many years now. Their ability to do so poses a serious empirical challenge to so-called "endogenous" money theories. I don't think any endogenous money proponent has a good explanation of how this is possible if the BoC is simply creating reserves "as needed" by the banking system.

    2. By controlling short rates?

  2. Great stuff!

  3. @Rural: I wasn't around but I suspect that Technical Report 16 was in the back of people's minds at the BoC when it abandoned M1...or should I say, when M1 abandoned the BoC!

    @marris: Welcome and thanks for stopping by. On the issue of the endogenous nature of the money supply, I think most central bankers recognize this fact. It's well known that when the monetary authority uses an interest rate operating procedure (rather than the monetary base), money is endogenous. I don't think anyone would deny that, at least in the short term. In the longer term, the evidence would appear inconclusive. As the late Alan Holmes of the NY Fed once put it: "over time", the central bank's influence on the stock of money "can obviously be felt".

  4. @circuit It's true that the CB can only target one measure and leave others to fluctuate. If the CB targets an interest rate, then they cannot control money supply or inflation without a really good model.

    If, on the other hand, the CB wants to do inflation targeting, they don't need a complicated model. Just declare what the price level should be it and it will get there. Arbitrage will adjust interest rates (price) and money supply (qty) until futures prices line up with the inflation target.

  5. On Marvin Goodfriend, I concur with your readers' comments!!
    On endogeneity, would that MMTers appreciate it's been around for a while as you and a few others do. It was a very good piece: http://bilbo.economicoutlook.net/blog/?p=21099

  6. Joseph Laliberté2 October 2012 at 20:34

    Two questions:
    1) what do you mean by "the capacity of self-financing"?

    2) do you include in "endogenous money" both the concept of horizontal money (originating from private debt) and vertical money (orginating from public debt, what MMT often calls net financial assets of the private economy)?

  7. The above article repeats the popular myth that it was Minsky who first noticed the destabilising effects of endogenous money. Walter Bagehot pointed to this phenomenon a century earlier. Indeed, the point is little more than a statement of the obvious: whence the booms and busts of the 1800s? They weren’t caused by gyrations in the size of the then monetary base, i.e. the stock of gold.

    Second, re the second paragraph, it is not correct to suggest that without endogenous money, all economic activity has to be “self-financing”. In a “gold coin only” monetary system (for example), there’d be nothing to stop one person lending gold coins to another.

    Third, I’ll take the claim that endo money leads to “improved living standards”. It’s certainly true that where an investor spots a viable project, borrowing the money is easier under an endo system than a monetary base only system. That’s because under the former, the bank doing the lending can create the savings required out of thin air. Apparently no one needs to cut consumption in order to enable to investment project to go ahead and consume resources.

    It sounds too good to be true, and it is. What actually happens is that the extra spending caused by the investment is inflationary (assuming the economy is already at capacity), which means purchasing power is stolen from existing holders of money. Either that or government controls the inflation by for example cutting spending on education, roads, health care, or whatever. In that case, consumption is stolen from those looking for education, health care, etc.

    Endo isn’t too clever.

    1. actually, FRB's claim has always been that 'endo is not the end all. check the treads. also check the Bagehot tread of January 3,. 2012. the readers have already been there and authors have already transcended the detail.
      i leave your second point to a more public forum. that take is not appropriate.
      however i take exception to your comment that 'extra spending caused by the investment is inflationary (of course at full capacity). refer to the St Louis Fed WP by Han and Mulligan: Inflation and the Size of Government. regardless, one can appeal to fiscal initiatives of varied types you can tax, immigration, investment and industrial policies can be fine-tuned to become more productive etc. (in policy, growth capacity is not a reflection of efficiency.
      as FRB says 'steering' is the secret of keynesian economic policy-not laissez-faire.

      i enjoy your blog, but in your blog scroll, you short your readers- you miss one of the best columnists in the Canada

    2. JH, it took me a few seconds to realize who you were talking about...thanks for the endorsement! Also, I'm struck by your comments on inflation. Very interesting. I'm curious about your statement suggesting that "in policy, growth capacity is not a reflection of efficiency". I suppose here you are saying that the mix of policies can help address any potential demand-pull inflation. Also, would it fair to say that inflation is perhaps secondary to other goals? I would agree with that...up to a limit, of course (I think we already agree on that point).

  8. JL: The basic point of this commentary was just to explain that the system can endogenously (from within) generate financing means regardless of the real resources backing them. Also, I wanted to explain that there are two sides to this. It can leave us better off or make us more vulnerable. The role of the policymaker is to help steer us in the direction and to find the right balance. Endogenous money is no panacea.

    RM: Thanks for your comment. Regarding Minsky, I don't deny others before recognized the instability of the system. In this post, I was just trying to show that the concerns of the BIS economists were shared by post-Keynesians too. As for the rest of your commentary regarding the endogenous nature of money, as I mentioned in the post and my comment to JL above, I agree with your general point: there is a real downside to it.

  9. For those readers that think Interest Rate adjustments are not effective in calibrating national accounts and support fiscal policy: please check the RBA's 0.25 basis point cut in their rates and the currency's decline on the spot. I will suggest that the immediacy of the impact is impressive and it's been like that for as long as I can remember (that's Long :)) It could take fiscal initiatives much longer than that.

    Nice recall on the BoC document!! Clinton & Lynch sounds very contemporary. As if bankers need MMTers to tell them how the system functions. I'm echoing an old refrain from an old colleague.

  10. Swells, the Aussie issue is very relevant. Canada should indeed take note. I'll keep an eye on it -- hopefully the effect will be sustained. I too have expressed skepticism regarding the effectiveness of a rate cut. Also, I take your point regarding the delayed impact of fiscal initiatives. I just think there's a gargantuan-size missed opportunity here on the part of Canadian governments to take advantage of this low-cost of borrowing, low-inflation environment. As I mentioned a while back, historians will look back and wonder at the lack of action (though, in the US, I suspect the actions of the Fed Chairman will be looked upon favorably). As for BoC TR 16, it's a real gem. Your colleague is right.