...against fictions and other tall tales

Sunday, 20 January 2013

Does the endogenous nature of money weaken the case for NGDP targeting?

One charge that's often directed against those who espouse nominal GDP targeting within a quantity theory framework (e.g., market monetarists) is that they fail to take into account the endogenous nature of money in their analyses.

In my view, such a charge is misplaced, as there are economists within the quantity-theory tradition who support NGDP targeting and who acknowledge the endogenous nature of the money supply.

Take, for instance, Robert Hetzel, senior economist at the Federal Reserve Bank of Richmond and a strong advocate of NGDP targeting (and sometimes considered a precursor of today's market monetarists).  Hetzel has a deep understanding of the operational aspects of central banking and recognizes the implications for policy formulation posed by the endogenous nature of money.  Consider the following:

First, Hetzel understands that credit creation is at the root of deposit creation (i.e., "loans create deposits") and that the supply of reserve balances is demand-determined in a monetary regime where the central bank targets an interest rate.  Here is an excerpt from Hetzel's 1986 paper "A Critique of Theories of Money Stock Determination":
Deposits and reserve demand are determined simultaneously with credit creation. As a consequence of defending its rate target, the monetary authority, by creating an infinitely elastic supply of reserves, accommodates whatever reserve demand emerges...In a regime of rate targeting, neither the quantity of reserves nor the desired reserves-deposits ratio of the banking system exercises a causal role in the determination of the money stock (1986:6)
Second, Hetzel recognizes the inapplicability of the textbook money multiplier model of money stock determination in monetary regime where the central bank targets an interest rate and understands that the main constraint imposed on banks (for credit creation) under such a monetary regime is the price of reserve balances set by the central bank rather than their quantity:
Interest rate smoothing by the monetary authority makes reserves and the money stock endogenous...Since [Chester] Phillips (1921), reserves-money multiplier formulas have been derived from a model of the banking sector summarized in the multiple expansion of deposits produced by an injection of reserves.  The existence of markets for bank reserves, however, renders this model untenable.  Phillips' model assumes that the individual bank is constrained by the quantity of its reserves and that its asset acquisition and deposit creation are driven by discrepancies between actual and desired reserves.  Given the existence of markets for bank reserves, such as the fed funds and CD markets, however, individual banks are constrained by the price, rather than the quantity, of reserves they hold. (1986:20) (emphasis added)
Third, Hetzel recognizes the operational implications of endogenous money for monetary control. Consider the following excerpt from his 2004 article "How does the central bank control inflation?":
Because the Federal Open Market Committee (FOMC) uses the funds rate rather than the monetary base or bank reserves as its policy variable, money is endogenously determined. (2004:48) 
Stated differently, Hetzel recognizes that when the central bank uses an interest rate instrument the central bank cannot exogenously control the money supply:
[W]ith an interest rate as the policy variable, monetary control does not imply an exogenous money stock. (footnote at 48)...In the case of an interest rate instrument, the central bank privatizes control over reserves provision by turning the decision on the quantity of reserves over to the financial market...It takes direct control over the setting of the interest rate (55)
Finally, Hetzel understands that central bank purchases of government debt is not in itself inflationary.  Consider the following statement made recently by Hetzel during a presentation in Europe:
Somehow the Buba has this idea that if you buy government debt, that in itself is inflationary. Well, you gotta buy something to be able to create the monetary base that sustains money creation. So you gotta buy something. And you can buy baskets of government debt. But buying government debt is not inflationary. That's pursuing it far too much. (75 minutes)
So what differentiates Hetzel's views from the one of Keynesian-inspired economists who accept the endogenous nature of money (such as post-Keynesians)?

To answer this question and better understand how Hetzel is able to reconcile the above views with his attachment to the quantity-theory tradition, it's important to understand that Hetzel's framework for analyzing monetary policy relies on a natural rate (of interest) model, in which monetary control depends on how well the central bank can adjust its interest rate in a manner that tracks the natural rate of interest (i.e., the real interest rate that would exist in the absence of monetary disturbances*).  This is where Hetzel differs entirely from post-Keynesians.

In Hetzel's view, as mentioned above, in a context of endogenous money, the central bank doesn't control money creation via the textbook money multiplier process or by exogenous injections or withdrawals of base money.  Rather, Hetzel views money creation as the consequence of the central bank keeping its interest rate below the natural rate.  The reverse, money destruction, occurs when the central bank keeps its interest rate above the natural rate.  Hetzel explains the difference between his and the old monetarist description of money creation as follows:
The real world counterpart to the quantity theory conceptual experiment of an exogenous increase in money is a failure by the central bank to move its interest target in a way that tracks the natural rate (2004:51).
In other words, in Hetzel's quantity theory framework, money creation and the monetary transmission mechanism has little to do with adjusting the size of the monetary base or manipulating the textbook money multiplier in such a way as to expand the money supply by means of a multiple expansion of deposits.  (One exception is in today's case, where the Fed has the ability to control the amount of reserve balances.  In such a context, Hetzel considers the money multiplier model of money stock determination as relevant given that the money supply expands as a result of open-market purchases.)

So if it's not the money multiplier, what's the monetary transmission mechanism then?

Another point of divergence between Hetzel's view and the post-Keynesian view -- and this is important for understanding his framework for boosting NGDP (and thus enabling the central bank to hit its NGDP growth target) -- is that he holds a view emphasizing the central bank's ability to force portfolio rebalancing by the public and thereby control the public's dollar expenditures.  Liquidity or portfolio rebalancing involves the purchase by the public of illiquid assets such as consumer durables, equities, real estate, etc.  Hetzel explains the central bank's ability to foster portfolio rebalancing as follows:
Assume that the central bank purchases an illiquid asset, for example, shares in a mutual fund holding equities.  The public will rebalance its portfolio through the purchases of physical assets like land and equities.  The rise in their prices will raise their value as collateral and this facilitates the access to credit of the holders of these assets.  Increased liquidity from increased access to credit augments the portfolio rebalancing effect by decreasing the demand for the liquidity services of money.  The increase in the price of physical capital relative to its replacement cost stimulates investment. (2004:56)
There is no need to get into the other aspects of Hetzel's framework in support of NGDP targeting (e.g., role of central bank credibility and inflation expectations, establishment of a monetary rule...) since it is not altogether relevant to the basic point of this post, which is to say that the arguments about the irrelevance of the money multiplier or the endogenous nature of money that are sometimes made to counter the case in favor of NGDP targeting don't get to the core aspects of the debate, such as the issue of the natural rate.


The point of this post is simple: the arguments concerning the endogenous nature of money and the irrelevance of the textbook money multiplier do very little to challenge the case in favor of NGDP targeting (or inflation targeting, for that matter) and the general theoretical construct used by market monetarists.  As I've shown, the case for NGDP targeting can be made (at least theoretically) using a quantity theory approach that is consistent with the endogenous nature of money.

Therefore, from a debating standpoint, those who support a functional finance approach to economic policy (as I do) would gain more by focusing their efforts on challenging notions such as the natural rate of interest and in demonstrating the inadequacies of an approach to monetary policy whose monetary transmission mechanism relies largely on the portfolio balancing effect.  While the issue of the natural rate is largely a theoretical problem (Does it exist? Can it be measured?), the question of the portfolio balance effect is essentially an empirical issue (Is the portfolio rebalancing effect substantial? Can the central bank control it for policy purposes?)

As for the bloggers and economists who think that post-Keynesians and MMT economists are wrong about the endogenous nature of money and its implications for central bank operations, I would suggest they review the work of Robert Hetzel.  His take on these matters is in line with the post-Keynesian/MMT view.

* Another definition is "the real rate of interest consistent with keeping real aggregate demand in line with potential output" (see here).  Without getting into too many theoretical details, from a practical standpoint, central bankers tend to interpret decreases in rates of resource utilization (increases in the unemployment rate) as indicative of a real interest rate in excess of the natural rate (and vice-versa).


Hetzel, R., A critique of theories of money stock determination, Working Paper, Federal Reserve Bank of Richmond, 1986

Hetzel, R., How Do Central Banks Control Inflation?, Federal Reserve Bank of Richmond, 2004

Federal Reserve Bank of San Francisco, The natural rate of interest, FRBSF Economic Letter, October 2003


  1. Very nice post and completely agree, though Hetzel is rare among neoclassicals. Even Krugman, for instance, believes in the qty theory of base money if you're not in his version of the liquidity trap.

    But this is why I focus on the various and offsetting transmission mechanisms of interest rates, the leverage vs. deleverage natures of monetary vs. fiscal policies, and the pvt sector's desired net saving over a business cycle, as rationales for functional finance.

    Scott Fullwiler

  2. Thanks Scott - I appreciate the nod. As for your work, I've always found your approach on these issues to be impeccable.

  3. That's quite a writeup circuit. Nods to you and SF for being candid in his own regard. It's again time to remind economists and the like that one's pretense to novelty in economics tends to backfire. It's like models, when you think you've got reality; that's when reality stuns your insights. Very much like quantum mechanics. In the case of economics, there's a lot of insight that's not being credited properly. Good that you and SF are around to nod the right thinkers and ideas, and correct the bad directions some taxis are taking. Hetzel, a very good mind like Domar, that deserves greater recognition. Hetzel is to banking what Domar was to policy: One can't appreciate Banking's impact on macroeconomics without courting Hetzel as one can't appreciate public policy without courting Domar and economic growth.

  4. Bob Hetzel's work makes for excellent reading. Even though I disagree with many of his views about the role of government in the economy (he's quite the free-market advocate), I still respect him immensely for his understanding of the system. Also, his skepticism about the need for a financial safety net always provides good food for thoughts. As I say, I don't always agree but he makes a good case.

    But as for your comment on models (nice insert!)...looks like reality has finally caught up to the textbook. Well, as I wrote, at least Hetzel sees it that way. Of course, many others within the FRS probably do as well.

    Lastly, I'm glad you think my recent postings on Domar and Hetzel were worthwhile. I have to say, it was great to re-read Domar's '93 article. If only today's media talking heads could take the time to study it.

  5. it seems to me i missed more than a boatload of excellent deliberations. it's good to read some serious ideas and respective comments: tracking work by Binder, Hetzel, Domar...i haven't seen the likes of this in decades. economics has to be tied into history. economic thought is serious business. some of the best ideas are already out there, but the community and policymakers are either too lazy or too proud to entertain them. i like GC's position that there are other traditions that can lead to good policy and cleaner economics. calling in Hetzel was marvellous! and Domar was a great ReFit. one needs daring to call upon history as a pathfinder.

    good new year's start circuit!!

    1. Good to hear from you, JH! I thought you might enjoy this Hetzel piece. I recall you citing on more than a few occasions the work of Hetzel's close colleague, M. Goodfriend. Combined, their work makes for a serious course in monetary econ. Also, I'm glad you approve of the Domar recall.

  6. Good to hear from jh. It's been a while jh. I thought you'd get a kick from reading Hetzel and Domar. Anyone who appreciates good economics enjoys the 'likes' of Blinder and that 'forgotten generation'. Who is anyone kidding. The likes of Blinder and others is revisiting the pantheon of titans-something like The Basilica of Santa Croce in Florence. Right GC. Then GC's 'other traditions' reminds me of Solow's ongoing conversations with contemporary economists and policymakers that some of the answers are back there on the shelves. All they need is, and I agree with jh's pertinent capitalization- a ReFit: great nuance!!! and you are certainly laying out the parameters. It's been great reading, and hopefully, we won't have to hear of the 'multiplier' effect any longer from the mmt fan clubs. I welcomed Scott Fulwiller's recognition that some conclusions have been around for a while. SF is a seriously good thinker.

    Maybe the mmt groupie's can learn to swim in deeper waters rather than the local pond. Economics is very 'serious business' for very good surfers and swimmers, not weekend paddlers and dabblers.

    Great conversations circuit!! Another good year

    1. "Then GC's 'other traditions' reminds me of Solow's ongoing conversations with contemporary economists and policymakers that some of the answers are back there on the shelves." SWELLS are you surprised??? who else but Bob Solow would have the DARE.