Two Views of Money and Implications for Monetary Policy

Last time we introduced money. I presented two views of money:
Here is a brief review

1. An exogenous story
2. An endogenous story

The first story is consistent with the neoclassical doctrine that money is neutral. The second is inconsistent with that. Why is the second inconsistent with the neutrality of money principle? Because money is that which allows us to settle our obligations as they come due. In the first story, there is no theory of debt. In the second, debt enters into the theory very explicitly.


Let me lay out these stories in more detail:

Exogenous story: The CB can control the money supply through the money multiplier. Money supply = k*reserve base ; where k = 1/rr and rr is the required reserve ratio. If the Federal Reserve stipulates that banks must hold 10% in reserves against their outstanding liabilities (deposits), then k = 1/.10 = 10. Thus, with a required reserve ratio of 10% reserves, the story goes that banks can create 10 times as much bank money as they hold in reserves. This is what lies behind the idea of fractional reserve lending.

In this story causality goes from reserves to money supply via the money multiplier. Hence, the central bank can control the money supply by controlling the quantiy of reserves available in the banking system, as well as by controlling the required reserve ratio.

The equation of exchange: The following expression is based upon one of the oldest ideas in economics: The Quantity Theory of Money. This can be traced back to David Hume (1752) and witnessed a rebirth in the mid-twentieth century by Milton Friedman and the "Monetarists" following in his stead. The following equation of exchange relates the quantiy of money to changes in prices.

MV = PQ ; where M is the money supply, V is the velocity of money (the average number times money circulates through the economy in a given period), P is the average price level, and Q is the level of real productive activity (the quantity of goods produced in a given period).

The equation can be used to tell the exogenous story as follows: Reading the equation from left to right, and invoking the assumption that the velocity of money is fixed in the short term, then changing the quantity of money changes PQ in the same direction. Therefore, increasing the money supply will cause nominal output (PQ) to increase. But, since in the neoclassical tradition, of which Monetarism and the exogenous story are certainly party to, money must be neutral. How then can changes in money affect output (increases in Q)? The answer is that individuals are fooled by the "veil of money." That is, they misinterpret nominal price changes for relative price changes. So, they see their nominal wages increasing and decide to "make hay while the sun shines," deciding to supply more of their labor to the labor market. This increases the production of goods and services. But, over time they realize that they've been hoodwinked! They will withdraw their level to the equilibrium level, and the only result of the money supply change will be a proportional increase in prices. Thus, "money is always and everywhere a monetary phenomena."

So, in the long-run (after agents figure out the trick) increasing the money supply simply increases prices. This is the basis behind our fears that "printing money" destroys the value of the currency. Because money changes do not affect the real economy in the long run, we say that money is neutral.

Endogenous story: This process is much different than the one described above. It is also the one that describes the world in which we actually live.

In this scenario, the federal reserve cannot control the money supply, because loans are extended prior to the acquisition of reserves. What the Fed can control is the Federal Funds Rate. The Fed can choose an interest rate target and hit it reliably. This suggests that the rate of interest is not determined by the bond market, but rather is administered "exogenously" by the central bank. Much the way a large corporation can set its prices, the Federal Reserve can set the price of money.

Banks create money when they make loans to credit worthy customers. When you go to the bank and apply for a loan - say a car loan - they do not check their reserves balances first. On the contrary, they evaluate you as a credit risk, and decide whether or not to make a loan to you given the outcome of the underwriting process. If you are a relatively risky customer, then they may charge you higher interest than they would their low risk customers, which is intended to compensate them for the possibility that you may default on your loan. Nevertheless, if they underwrite the loan then a new asset is created for the bank (this is now your liability), and simultaneously it credits you bank account, creating an equal and offsetting liability for the bank. For example, if you borrow $10 thousand to purchase a car the bank increases its assets by $10, and increases your demand deposits by $10 thousand. The loan is their asset and your liability. The demand deposits are their liability and your asset.

Hence, loans create deposits. This runs counter to what people usually think about money creation, which is something along the lines of this: I deposit $100 in the bank. The bank then leverages my $100 into $1,000 which is then loaned out. That is the conventional wisdom, for sure, but it doesn't work that way at all.

But what about the required reserve ratio? Isn't the bank required by law to keep some proportion of reserves on balance against its liabilities? Yes it is, but that ratio is not required to be maintained instantaneously. Nor is it practical to do so. There is an accounting period - about two weeks - at the end of which the reserve ratio must be validated. If the bank falls short of the reserves necessary to be in compliance with the law, then it must borrow them in the federal funds market. Otherwise, they can be obtained directly from the Federal Reserve. The Fed will always supply the reserves necessary to ensure that banks meet this requirement, therefore reserves do not constrain bank lending.

The endogenous story reads the equation of exchange from right to left:

MV = PQ.

That is, changes in the volume of economic activity (increases in PQ) drive changes in the volume of money in circulation. From this perspective - i.e. when money is created on demand by bank lending - then the notion that there can be too much money in the economy possesses no meaning. Therefore, endogenous money rejects the statement that, "inflation is always and everywhere a monetary phenomena." Instead, inflation is caused by firms with market power attempting to raise their profit markups, or in the rare case that the economy runs up against the full employment barrier, a state in which there are too few goods produced to go around, causing the price for those goods to rise.