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In economics, endogenous money refers to the theory that money comes into existence driven by the requirements of the real economy and that banking system reserves expand or contract as needed to accommodate loan demand at prevailing interest rates. It forms part of Post-Keynesian economics. This theory is based on three main claims:
Therefore the quantity of broad money in an economy is determined endogenously: in other words, the quantity of deposits held by the non-bank sector 'flexes' up or down according to the aggregate preferences of non-banks. Significantly, the theory states that if the non-bank sector's deposits are augmented by a policy-driven exogenous shock (such as quantitative easing), the sector can be expected to find ways to 'shed' most or all of the excess deposit balances by making payments to banks (comprising repayments of bank loans, or purchases of securities).
Central banks implement policy primarily through controlling short-term interest rates. The money supply then adapts to the changes in demand for reserves and credit caused by the interest rate change. The supply curve shifts to the right when financial intermediaries issue new substitutes for money, reacting to profit opportunities during the cycle. Even if the monetary authority refuses to accommodate such changes, banks can still increase reserves for loan demand through their own initiatives.
Given available credit, investment precedes and 'forces' the saving necessary to finance it. Investment determines saving rather than the converse since, in the modern world, no saving can appear without income being distributed, and no income can be distributed without entrepreneurs getting into debt. Therefore, investment plans do not need to consider savings. At times of a positive balance of payments, banks do not retain excess reserves, either lending the excess to other banks that are running a deficit on their balance of payments, by purchasing government debt for profit. It is precisely the credit-creation process dictated by profit seeking motives that is the source of instability.
Governments and central banks, both as lender of last resort and as regulator of financial practices, help monitor the level and quality of debt, and can stop a downward profit trend, which is the key variable for debt validation and for asset prices.
Proponents deny any practical impact of the money multiplier on lending and reserves.
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Theories of endogenous money date to the 19th century, by Knut Wicksell[1], and later Joseph Schumpeter.[2]
According to Hyman Minsky, the money supply is the sum of high-powered money and demand deposits. Minsky’s financial instability hypothesis claims that this quantity is inherently unstable. His "financial instability hypothesis" starts with a high level of investment due to a high rate of profits. These profits provide cash flows to service debt which in turn yields more profits and leads to a boom in equities. Rapid output growth forces firms to take on more debt to expand production. Over time, investors come to underestimate financial risk during the boom. Eventually, interest rates surge, which forces debtors to roll once-affordable interest payments into ever-higher principal amounts. If rates remain high, more and more investments turn into "Ponzi schemes. Financial euphoria slowly changes to financial panic; lenders start to lose confidence in the future, asset prices decline. Eventually, borrowers can no longer refinance, gross profit eventually collapses and investment falls or even stops.
Consequently, over a period of time an economy can become susceptible to debt deflation. To avoid deflation and a lasting depression, the central bank is expected to ‘bail out’ the financial system by providing fresh reserves to increase liquidity and reduce cost of funds. Changes in the quantity of money have a limited direct impact on the economy as a means of mitigating financial crisis. Conversely, financial crises do not depend on a rapidly increasing money supply.
Endogenous money is a heterodox economic theory with several strands, mostly associated with the Post-Keynesian school. Multiple theory branches developed separately and are to some extent compatible (emphasizing different aspects of money), while remaining united in opposition to the New Keynesian theory of money creation.
Mainstream (New Keynesian) economic theory states that the quantity of broad money is a function of the quantity of "high-powered money" or "government money" (notes, coins and bank reserves), and the money multiplier (the inverse of the reserve ratio).
New Keynesian economists believe that when a bank has no excess reserves, new credits can only be granted if banks increase deposits, which occurs when the central bank purchases government bonds (from banks or public) on the open market, thereby changing the amount of excess reserves. Monetary authorities can use either interest rates or the quantity of money, generally favoring the former during the Great Moderation.
They further suggest that periods of instability are short-lived and result from supply and demand "shocks". Such shocks reduce the value of existing capital stocks. They typically result from action/inaction by central banks and governments. They claim that government intervention itself commonly leads to poor capital allocation, e.g., when central banks keep real interest rates below ‘equilibrium’ rates.
| Endogenous | Exogenous | |
|---|---|---|
| Quantity of money | Endogenous | Endogenous or exogenous |
| Policy tool | Interest rates | Interest rates (including on excess reserves), open market operations, expectations |
| Causality | Investment drives money | Savings/quantity of money and expectations can drive rates |
| Money multiplier | Irrelevant | Relevant |
| Stabilization | Government-led | Market-led |