Endogenous_money_supply

What Is Endogenous Money Supply?

Endogenous money supply refers to the theory within monetary economics that the amount of money in an economy is determined by the demand for credit from the private sector, rather than being solely controlled by a central bank. In this view, commercial banks create money primarily through the act of making loans, leading to the creation of new bank deposits. This perspective contrasts with the traditional view that central banks directly control the quantity of money through exogenous means. The concept posits that the supply of money adjusts "endogenously" or from within the economy, in response to economic activity and the banking system's ability to facilitate credit creation.

History and Origin

Theories of endogenous money supply have roots stretching back to the 19th century with economists like Knut Wicksell, and later Joseph Schumpeter. Early versions of this theory also appeared in Adam Smith's The Wealth of Nations (1776). A significant development in the endogenous money approach stemmed from the realization that central banks, acting as a lender of last resort, supply reserves to commercial banks as needed.¹³

In modern times, central banks, including the Bank of England and Deutsche Bundesbank, have published papers acknowledging that money creation primarily occurs through commercial banks making loans, challenging the older "money multiplier" model. For instance, the Bank of England stated in a 2014 bulletin that "Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they 'multiply up' central bank money to create new loans and deposits." S¹²imilarly, the Deutsche Bundesbank noted in 2017 that a bank's ability to grant loans and create money is not dependent on prior excess reserves or deposits.

¹¹## Key Takeaways

• The endogenous money supply theory posits that money is primarily created by commercial banks through lending, driven by private sector demand for credit.
• Central banks influence the quantity of money indirectly, mainly by setting interest rates, rather than directly controlling the money supply.
• This perspective emphasizes the demand-driven nature of money creation, where loans create deposits, reversing the traditional textbook sequence.
• The endogenous money framework highlights the adaptive role of bank reserves, which are supplied by the central bank as needed to meet the demand for credit.
• Understanding endogenous money supply is crucial for analyzing modern monetary policy and its impact on the real economy.

Interpreting the Endogenous Money Supply

Interpreting the concept of endogenous money supply means understanding that the quantity of money in an economy is not a fixed variable determined solely by the central bank. Instead, it is responsive to the needs and activities of the private sector. When businesses and individuals demand loans, commercial banks create new deposits, thereby expanding the money supply. The central bank's role then becomes one of influencing the price of money through policy interest rates, such as the federal funds rate, which in turn affects the willingness of banks to lend and borrowers to borrow.

¹⁰The core implication is that the supply of bank reserves, which banks hold at the central bank, is largely a consequence of the demand for credit and the subsequent need for banks to settle payments. Central banks accommodate this demand for reserves, albeit at a price (the policy rate). This adaptive nature of reserves means that reserve requirements, where they exist, do not typically constrain a bank's ability to lend in the first instance.

⁹## Hypothetical Example

Consider a growing economy where businesses are optimistic about future sales and decide to invest in expanding their operations. A manufacturing company, "Widgets Inc.," needs $5 million to build a new factory. Widgets Inc. approaches its commercial bank, "Growth Bank," for a loan.

1. Loan Approval: Growth Bank assesses Widgets Inc.'s creditworthiness and approves the $5 million loan.
2. Deposit Creation: Rather than transferring existing funds, Growth Bank digitally creates a new $5 million deposit in Widgets Inc.'s account. At this moment, new money has been created in the economy. Growth Bank's balance sheet expands, with the loan as an asset and the new deposit as a liability.
3. Spending and Settlement: Widgets Inc. then uses this $5 million deposit to pay contractors, suppliers, and employees. These payments move the newly created money to other accounts, potentially at other banks.
4. Reserve Management: As money moves between banks, Growth Bank may find itself with a deficit of reserves at the central bank, while other banks gain reserves. Growth Bank will then borrow reserves from other banks in the interbank market or from the central bank, at the prevailing policy rate, to settle these transactions. The central bank will supply the necessary liquidity to ensure the smooth functioning of the payment system.

This process illustrates how the initial demand for credit from Widgets Inc. led directly to the creation of new money by Growth Bank, with the central bank accommodating the resulting reserve flows.

Practical Applications

The understanding of endogenous money supply has several practical applications in economics and finance:

• Monetary Policy Formulation: Central banks now widely acknowledge that their primary lever is the setting of short-term interest rates, which influences the cost and demand for credit, rather than directly controlling the quantity of money in circulation. This affects how central banks conduct monetary policy.
  *⁷, ⁸ Understanding Inflation: If money creation is primarily demand-driven, then rapid credit expansion not matched by real economic growth can lead to inflationary pressures. Policy responses often focus on managing credit demand through interest rates.
• Financial Stability Analysis: The endogenous nature of money creation means that the health and behavior of the commercial banking sector are central to the stability of the entire financial system. Excessive or irresponsible credit creation can lead to financial imbalances.
• Quantitative Easing (QE): During periods of low interest rates, central banks might resort to measures like quantitative easing to directly influence financial asset prices and encourage broader credit expansion. While QE creates central bank money (reserves), its effectiveness in stimulating broad money growth depends on commercial banks' willingness to lend and the private sector's demand for loans.

⁶## Limitations and Criticisms

While the endogenous money supply theory has gained significant traction, it faces certain limitations and criticisms:

One primary critique is that while commercial banks create money through loans, their ability to do so is not entirely unconstrained. Central banks, through their control over benchmark interest rates and regulatory frameworks, still significantly influence the terms and volume of lending. For example, a central bank raising its policy rate makes borrowing more expensive for commercial banks, which then typically pass on these higher costs to borrowers, thereby dampening loan demand and credit creation.

⁵Furthermore, the theory sometimes downplays the role of non-bank financial institutions and other forms of liquidity in the economy, which can also influence the overall money supply. Some economists also argue that the money supply is neither perfectly endogenous nor exogenous, but rather a mix of both, with central bank actions still having considerable impact. T³, ⁴he effectiveness of quantitative easing in directly boosting broad money supply, rather than just bank reserves, has also been a point of debate, with some arguing that demand for credit remained low despite increased bank liquidity.

¹, ²## Endogenous Money Supply vs. Exogenous Money Supply

The primary distinction between endogenous money supply and exogenous money supply lies in the perceived source of money creation within an economy.

Confusion often arises because, in practice, central banks do exert significant influence over the economy and financial conditions. However, the endogenous perspective argues this influence is primarily through the cost of money, affecting loan demand and thus the money supply, rather than directly dictating its quantity.

FAQs

How do commercial banks "create" money?

Commercial banks create money when they make new loans. When a bank approves a loan, it simultaneously creates a corresponding deposit in the borrower's account. This new deposit is new money entering the economy, not just a transfer of existing funds.

Does the central bank have no control over the money supply then?

Central banks do not directly control the quantity of money in an endogenous system. Instead, they primarily influence the supply indirectly by setting benchmark interest rates. These rates affect the cost of borrowing for commercial banks and, subsequently, the interest rates banks charge customers, which influences the overall demand for loans and, therefore, the rate of credit creation.

What is the difference between base money and broad money in this context?

Base money (or high-powered money) refers to the currency in circulation and commercial banks' reserves held at the central bank. Broad money, which is the focus of endogenous money theory, includes bank deposits held by individuals and firms, in addition to currency. In an endogenous system, commercial banks create broad money through lending, and the central bank then supplies the necessary base money (reserves) to support the interbank payment system.

Does endogenous money mean that banks can lend without limit?

No. While banks create money when they lend, their ability to do so is constrained by several factors. These include borrower demand for loans, the bank's capital requirements, its profitability considerations, and the central bank's monetary policy stance, particularly its setting of interest rates. Banks also need to manage their liquidity and funding positions.