Where Does the Money Come From? Exogenous vs Endogenous Money Growth

Whether or not money growth is exogenous or endogenous has been hotly contested within the study of Economics. First came Milton Friedman’s revolution of Monetarism which attributed money supply growth to purely exogenous factors. At the time, this development had swamped the dominant Keynesian economists as their models were simply unsuitable when trying to integrate Friedman’s logic and proposal. Nowadays, the literature has developed to favour the notion that money growth is endogenous since Nicholas Kaldor’s critique of money being largely created by private banks through debt. This doctrine has been well received, yet, with the recent inflationary crises, the credibility of Central Bankers has been questioned. Intellectuals such as Tim Congdon have challenged the Keynesian focus on the natural rate of interest by suggesting that policies such as QE (which in this view exogenously influences money growth) have a much larger weighting on inflation than current models suggest. As such, to answer whether or not money growth is exogenous or endogenous, the following column will take two approaches. First, we examine and look at Dr. Joeri Schasfoort’s Agent-Based Model for Monetary policy transmission to look at endogenous factors. Then, we examine Wynne Godley’s sectoral balance equations to review how measures such as Quantitative Easing apply to these theories.

Schasforrt et al’s Agent-Based Model for the various transmissions of Monetary Policy can be best described as having a large focus on changes within interest rates. This is because the model begins its transmission by looking at both the lending and deposit facilities, which directly influence commercial bank deposit and loan rates. For our analysis, we have taken Schasfoort’s model and adapted it to show a reduction in the base interest rate set by the central bank as in the original analysis, he and collaborators chose to model an increase in the interest rate.

Another adaptation that we have made is a change in the transmission of the Bank Deposit Rate to the Wealth & Income flow. In the original model, a higher Bank Deposit Rate led to an increase in Wealth & Income as consumers saw an increase in the interest earned on cash held in deposit accounts. Instead, we have opted to increase Wealth & Income as we assume consumers and households hold wealth which according to the results of the model, will appreciate with an increase in Firm Net Worth as asset prices rise.

Schasfoort et al., shows endogenous money creation by deriving Loan Supply (newly created money) from Loan Demand due to higher Investment or higher Firm Net Worth. This is significant for a few reasons. First, it shows that the willingness of banks to provide loans is derived from real factors in the economy. This is because a firm's willingness to invest is ultimately a case of whether or not there is potential for future profits to be earned on said Investment. Second, banks only supply loans when there is money to be made, in other words, when there is demand. Although overlending can make a commercial bank unprofitable, overall, commercial banks create money in the economy almost freely and a common misconception is that they require deposits to do so. Building upon the model, banks receive payment on assets such as loans but also have to pay out interest on liabilities such as saving accounts. Therefore, a bank's business model is reliant on receiving higher rates of interest on loans than the rate paid on deposits. As such, in this analysis, a reduction in the rate of interest due to policy changes made by the Central Bank makes this spread wider, allowing for commercial banks to supply larger quantities of Loan Demand in a more profitable & sustainable manner. This builds a strong argument for endogenous money creation as, without Demand, which is derived from real (endogenous) factors, supply would not exist.

Although Schasfoort et al’s Agent-Based Model enables a deeper understanding of how money is created endogenously, unfortunately, the model is limited. The model does not account for the asset price channel as the paper claims firm investment decisions are based on desired growth of output which is influenced by real factors. This means that the model does not consider the implications of Quantitative Easing in increasing the value of assets such as assets and corporate bonds to boost Firm Net Worth. However, we believe that this assumption is severely misplaced, and it is not only Schasfoort et al that has ignored the implications of Quantitative Easing. The Stock-Flow Monetary Framework is a method of tracking national income outflows and inflows through double-entry bookkeeping. To show this, we recall an equation proposed by Wynne Godley below.