What Is Exogenous money supply?
Exogenous money supply refers to a theoretical framework within monetary economics where the quantity of money supply in an economy is determined independently by an external authority, typically the central bank. In this view, the central bank has precise control over the total amount of money in circulation and can directly influence it through its various monetary policy tools. This perspective suggests that the central bank can set the money supply at a specific level, and commercial banks and other financial institutions operate within this given constraint. The concept of an exogenous money supply underpins many traditional macroeconomic models, where changes in the money supply are seen as a primary driver of inflation and economic growth.
History and Origin
The concept of an exogenous money supply is deeply rooted in classical and neoclassical economic thought, particularly with the rise of central banking. Historically, the belief that a central authority could directly control the quantity of money gained prominence with the establishment of central banks in the late 19th and early 20th centuries. These institutions were tasked with managing a nation's currency and ensuring financial stability. Early central banks, like the Federal Reserve System created in 1913 in the United States, aimed to consolidate currency instruments and provide stability, often managing reserves and influencing the banking system to control the money in circulation.4 This era saw the development of tools such as open market operations, discount rates, and reserve requirements, reinforcing the idea that the money supply was a variable directly set by the monetary authority.
Key Takeaways
- Central Bank Control: The exogenous money supply theory posits that the central bank directly controls the quantity of money in the economy.
- Policy Tool: It views the money supply as an independent variable that can be manipulated by policymakers to achieve macroeconomic objectives.
- Influence on Economy: Changes in the exogenous money supply are believed to directly affect interest rates, aggregate demand, and price levels.
- Traditional View: This concept is a cornerstone of traditional monetarist and neoclassical economic models.
- Foundation for Tools: It provides the theoretical basis for instruments like open market operations to manage liquidity.
Interpreting the Exogenous money supply
In models where the money supply is considered exogenous, its interpretation is straightforward: the central bank's policy decision directly dictates the amount of money available in the economy. For instance, if a central bank announces a target for the growth rate of the money supply, this target is assumed to be fully achievable and controllable. Economists interpret an increase in the exogenous money supply as an expansionary monetary policy, expected to lower interest rates, stimulate credit creation, and boost aggregate demand. Conversely, a decrease signals a contractionary stance, aiming to curb inflation by reducing liquidity. This perspective implies that central banks can precisely fine-tune the economic environment by adjusting the money supply, assuming a stable relationship between money, prices, and output.
Hypothetical Example
Consider a hypothetical economy where the central bank operates under the assumption of an exogenous money supply. Facing a period of sluggish economic activity and low inflation, the central bank's monetary policy committee decides to stimulate growth. Under this exogenous framework, they might announce an increase in the money supply by a specific percentage. To achieve this, the central bank would conduct open market operations, such as purchasing government bonds from commercial banks. This action injects new reserves into the banking system. The increase in reserves is then expected to lead to more lending by banks, lower interest rates, and ultimately, an expansion of the overall money supply as defined by the central bank's target.
Practical Applications
The concept of an exogenous money supply has practical implications primarily within the realm of monetary policy and economic modeling. Central banks, especially historically, have based their policy implementations on the ability to control the money supply directly. One of the primary tools used to exert this control is open market operations, where the central bank buys or sells government securities to inject or withdraw money from the banking system. For example, the Federal Reserve uses open market operations to influence the federal funds rate, which, in turn, impacts other short-term and long-term interest rates in the economy.3
This framework is also foundational to various macroeconomic models that analyze the impact of monetary policy on key economic variables like inflation and output. Policies like quantitative easing, while unconventional, can be understood within a broader exogenous framework, as they represent large-scale asset purchases by the central bank designed to directly inject liquidity and influence financial conditions.
Limitations and Criticisms
While influential, the concept of an exogenous money supply faces significant limitations and criticisms, particularly from proponents of endogenous money supply theories. A primary critique is that the central bank's control over the money supply is not as direct or absolute as the exogenous view suggests.2 Critics argue that the money supply is largely determined by the demand for loans from businesses and consumers, and the willingness of commercial banks to lend, rather than being solely dictated by the central bank's actions. This implies that credit creation within the private banking system plays a more significant role in determining the actual money in circulation.
Furthermore, the effectiveness of central bank tools like manipulating reserve requirements to control lending has been questioned, as banks may often hold excess reserves or find alternative funding sources. The debate about whether money is truly exogenous or endogenous is one of the most important and intriguing discussions in monetary economics, with some arguing that the reality is a mix depending on various factors and institutional details.1 This challenges the simplistic notion that central banks can precisely determine the money supply irrespective of market demand and bank behavior.
Exogenous money supply vs. Endogenous money supply
The debate between exogenous money supply and endogenous money supply represents a fundamental divergence in monetary theory. The exogenous money supply theory, often associated with monetarism, posits that the central bank is the primary determinant of the money supply, controlling it independently through policy tools. In this view, changes in the money supply are a cause of changes in economic activity.
Conversely, the endogenous money supply theory argues that the money supply is primarily determined by internal economic processes, specifically the demand for credit from the private sector and the lending decisions of commercial banks. From this perspective, money is "created" when banks extend loans, and the central bank's role is largely to accommodate the banking system's demand for reserves to meet its interest rate targets. The central bank influences the price of money (interest rates) rather than directly controlling its quantity. While the exogenous view sees the money supply as the independent variable that drives the economy, the endogenous view often sees it as a dependent variable, reacting to the needs of the real economy.
FAQs
How does the central bank control an exogenous money supply?
Under the exogenous money supply theory, the central bank uses tools like open market operations (buying or selling government securities), adjusting the discount rate (the interest rate at which banks can borrow from the central bank), and setting reserve requirements for banks. By manipulating these tools, the central bank aims to directly increase or decrease the amount of money in circulation.
What is the main assumption of exogenous money supply?
The main assumption is that the central bank has complete and direct control over the total quantity of money in an economy, acting as an external force that can precisely set the money supply independent of commercial bank lending or public demand.
Why is the debate between exogenous and endogenous money supply important?
The debate is crucial because it affects how economists and policymakers understand the effectiveness of monetary policy. If money is truly exogenous, central bank actions can directly steer the economy. If it's endogenous, the central bank's influence might be more indirect, focusing on interest rates and financial conditions rather than the quantity of money itself, and recognizing the significant role of the private banking system in money creation.