Exogeneity of money

The question of exogeneity or endogeneity of money is one of

the most frequently debated topics within the domain of
monetary economics. Neoclassical monetarists typically
assert the position of exogeneity, while many post-Keynesian
economists tend to lean toward the endogenous position,
debating the extent to which the money supply is purely
endogenous (Kaldor 1970; Moore, 1988). However, the
current argument does not seem to revolve around whether
the money supply is purely exogenous or endogenous, but
rather on the extent to which the supply of money is
determined by exogenous or endogenous factors.

What does history suggest with regard to the

exogeneity/endogeneity of money?

 It’s important to first analyse the dialectics of the history

of money before beginning to form an argument about
whether money is exogenous or endogenous within the
modern economy. Somewhat surprisingly, the original
creation of money is heavily disputed.
 Individuals such as Knapp (1924) argue that money
was introduced into the economy by a central
authority, placing his argument in the exogenous
category.
 Contrastingly, Menger (1871, 1883, 1892) argues
that money developed not as a result of the
authorities, but instead that it was created
spontaneously as a result of the product of
unplanned market mechanisms. In short, his
argument suggested that certain commodities became
money naturally as they reduced the effort and time
needed to trade.
 The evolution of money is also further disputed as
to whether it evolved endogenously or
exogenously.
  According to Thornton (2000), the evolution to fiat
money from commodity money was a result of
individuals looking to cut down on production and
transaction costs; this is because it required
significant resources to create commodity money.
Hence, society endogenously replaced this commodity
money with a cheaper version, i.e. fiat money.
 Other economists (e.g. Hülsmann, 2008) argue that
fiat money didn’t appear endogenously as a result of it
being seen as a cheaper alternative, but instead as a
result of exogenous government intervention.

What are the current arguments for the exogeneity of

money?

Monetarists are highly concerned with the development of

the Quantity Theory of Money which is strongly linked with
the idea of the exogeneity of money supply. Monetarists
believe that monetary authorities (namely the central bank)
have control over the quantity of high-powered money and
that there exists a strong relationship between this money
base and the money supply. This management of the money
supply is conducted through open market operations and
reserve ratios. Keynes (1936) in “The General Theory of
Employment, Interest and Money”, concluded that the money
supply was an exogenously determined variable, his
reasoning being that the money supply is represented in the
quantity of money supplied by the monetary authority.
Moreover, the members of the Chicago School (e.g.
Friedman, 1970) concluded that the money supply was an
exogenously determined variable with the resurrection of the
Fisher equation MV=PY, where the money supply (M) is
treated as an exogenous variable, the demand for money
(1/v) remains stable, and any movement in money will
proceed a movement in nominal income. The implication of
these factors is that any changes made by central banks to
the money supply will be the main cause of the fluctuations
on the macroeconomic level (Edgmand, 1987).

Moreover, under the gold standard, there is also a strong

argument for the money supply being exogenous. This is
because the stock of gold within the economy can’t be
merely increased. In a full-reserve system, there would be no
means by which commercial banks would have the ability to
create money, and in a fractional-reserve system, the
commercial banks would still require gold reserves which
can’t simply be increased at will, thus within a gold standard
system the exogenous argument seems to hold as there is an
exogenous restraint upon credit creation (Sieroń, 2019).
There is also the suggestion that under a fiat standard, the
money supply is an exogenous variable. This is because,
when the monetary system is under a fiat standard, the
central bank is regarded as a monopolistic producer of money
and thus can fix the outside supply of money to be whatever
it would deem necessary. Although, in reality, it can decide to
respond to the needs of the commercial banks. It would also
be remiss to ignore the exogenous view that commercial
banks need reserves from the monopolistic central bank
before they’re able to grant loans on top of them (Sieroń,
2019).

What are the current arguments for the endogeneity

of money?

Following the financial instability between the world wars and

the abandonment of the Gold Standard in the early
20th century, criticisms of neoclassical monetary economics,
and its allegiance to exogeneity, started to become more
pronounced. Many of these academics came from the
Cambridge School (Kahn, 1972; Kaldor, 1970; Robinson,
1956) and the ideology from these pioneers has been
developed by other economists since the 1970s (Davidson,
1978; Graziani, 1984; Parguez, 1984) and most notably
Moore (1988). These individuals have mainly supported
interest-rate-based, fine-tuning policies, which have come
about as a result of empirical findings. This has led to the
gradual abandonment of central banks setting monetary
targets, with them now favouring interest-rate targets
(Blinder, 1997). The main reason behind this finding is
typically attributed to the fact that financial markets are
considerably more volatile than goods markets (Fontana,
2004). This instrumentalist approach is seen as an integration
of mainstream central banking practice with the
understanding that monetary aggregates adjust
endogenously (Fontana et al., 2020; Laidler, 2002).
Furthermore, in dynamic stochastic general equilibrium
(DSGE) models, monetary aggregates are often regarded as
residual variables within the system of equations, or viewed
as highly unpredictable (Bank of England, 1999; Federal
Reserve Board, 1996).

Another important area to analyse in terms of the argument

in favour of endogeneity is the area of unconventional
monetary policy. When the short-term interest rate is at, or
close to, the zero lower bound, the options of a central bank
are extremely limited as they’re unable to lower the cost of
money further. This has led to the proposition that monetary
policy is almost entirely ineffective at the zero lower bound
(Krugman et al., 1998). Central banks then believe they have
to resort to quantitative easing to solve this issue.
Quantitative easing programmes, introduced originally in the
wake of the GFC of 2007-2008, were evidently of monetarist
origin, as the reasoning behind the programmes would be
that increasing the liquidity of financial institutions would
lead to a boost in lending and hence consumption. However,
these programmes demonstrated that the worry of inflation
following an expansion in the money supply was groundless
(Lavoie, 2017). For example, the expansion of the money
supply in the UK after quantitative easing programmes
initially lagged behind the increase in monetary reserves.
During this period, the US money multiplier had also fallen
below unitary (Mankiw, 2009) as banks were piling up their
excess reserves. Hence, the quantitative easing programmes
are a great counterexample to exogenous-based, monetarist
thinking, as this increase in the liquidity of commercial banks
didn’t lead to an immediate increase in the money supply as
banks were unwilling to lend due to low animal spirits. In
short, banks do not lend more simply because of an increase
in their reserves (Sieroń, 2019). Extending this idea further,
the supply of money can also be determined by firms’
requirements to finance the costs of production. Hence, the
demand for loans is generated by the production choices
made by firms (Moore, 1988). Commercial banks establish
the interest rate for loans on top of the base rate and then
meet the loan demand, thereby rendering money
endogenous. This chain of reasoning acts as an explanation
for the failure of the monetarist-based quantitative easing
programmes; whilst banks had high levels of liquidity,
demand for credit by firms was extremely dire due to low
animal spirits, thus the money supply stagnated over this
period.

Some have also proposed that quantitative easing could be

accompanied by a reduction in the interest rate that central
banks pay on the excess reserves of commercial banks. This
argument is predicated on the idea that commercial banks
would not be incentivised to hold on to excess reserves if the
return on the excess reserves were to be reduced. Thus,
commercial banks would likely lend out more of their excess
reserves, stimulating economic activity. However, as
previously noted, banks will not extend loans if there is no
demand for them. During periods where central banks would
be carrying out these measures, demand for credit would be
extremely low, hence even if the banks wanted to extend
loans there would likely be no firm to extend one to. In such
situations, expansionary fiscal policies appear to be the sole
method to revive an ailing economy (Lavoie, 2017). This has
brought into question the independence of central banks, as
to function effectively, the central bank would be required to
coordinate itself effectively with the government in order to
successfully undertake unconventional monetary policies
(Fontana et al., 2020). It seems that, under independence, a
central bank is only capable of carrying out ‘defensive’
operations, as they have no power in controlling the demand
for reserves (Bindseil, 2004; Fullwiler, 2003). This has led to
many central bank officials stressing the endogenous nature
of monetary reserves and bank loans.

The arguments undermining the exogenous theory of money

aren’t just limited to the above. Many other prominent
economists have proposed arguments against exogeneity,
such as the fact that loans have a large role over deposits
(Disyatat, 2011) and how the deposit multiplier view isn’t
necessarily the correct one (Carpenter & Demiralp, 2012;
Kydland & Prescott, 1990; Lombra 1992). Jakab & Kumhof
(2015), who work for the Bank of England and the IMF
respectively, also seemed to have openly accepted
endogenous-based thinking, with the distinction they made
between the ILF (Intermediation of Loanable Funds) banking
model and the FMC (Financing through Money Creation
Model). The FMC model is more akin to the model developed
by Moore (1988). This is evidence that the view of money as
an endogenous variable is no longer constrained by
heterodox thought, with the Bank of England and IMF
seemingly beginning to accept the principle tenets of
endogenous monetary theory.

Conclusion

The question does not seem to be about the extent to which

money is exogenous, but rather the extent to which money is
endogenous. A clear distinction must be made as the
direction of economic thought seems to be heading towards
endogeneity rather than exogeneity – and with good reason.
The exogenous approach to money feels outdated, with the
classical theory of the interest rate, the money-multiplier
story and the quantity theory of money seeming more
applicable to an early 20th-century economy under the gold
standard rather than a modern 21st-century economy under
a fiat currency system. The failures of unconventional
monetary policy are proof enough to show the failures of
exogeneity, proving that external authorities (namely the
central bank) seem to have little control over the money
supply. Moreover, the acceptance of endogenous monetary
theory by supra-national institutions, such as the Bank of
England and the IMF, is further proof that the endogenous
side of the argument holds stronger than that of the
exogenous. It should also be noted that the endogenous side
isn’t just being accepted but is being actively implemented in
a new generation of endogenous-money-like DSGE models
(Fontana et al., 2020) which will reshape standard
macroeconomic modelling in the future. This is not to say
that money is completely an endogenous phenomenon, the
money supply is still certainly influenced by exogenous
factors. Central banks still set interest rates and engage in
large-scale asset purchases which have effects on the money
supply. Hence, the money supply is neither perfectly
exogenous nor endogenous, but it certainly seems the
debate is leaning further towards the endogenous side of the
argument than ever before.