Financial Economics Lecture Eight

1
Financial Economics Lecture Eight

• Theory of endogenous money

2
Moore on endogeneity

• Changes in wages and employment largely
  determine the demand for bank loans, which in
  turn determine the rate of growth of the money
  stock. Central banks have no alternative but to
  accept this course of events, their only option
  being to vary the short-term rate of interest at
  which they supply liquidity to the banking system
  on demand. Commercial banks are now in a position
  to supply whatever volume of credit to the
  economy that their borrowers demand. (Moore 1
  3-4)
• In a nutshell
• The supply of money credit is determined by the
  demand for money credit. There is no
  independent supply curve as in standard micro
  theory
• All the state can do is affect the price of
  credit (the interest rate).

3
Moore on endogeneity

• Conventional economic theory springs from the
  facts that
• Once, money was gold and silver coin
• Today, bank notes are state-issued legal tender
• And treats the latter as just a variant of the
  former
• Endogenous money theorists look instead at the
  invention of credit, when negotiable notes were
  first issued by private banks
• The crucial innovation was the finding that a
  banking house of sufficient repute could dispense
  with the issue of gold and silver coin and
  instead issue its own instruments of
  indebtedness. The payability of bank IOUs to the
  bearer rather than to a named individual made
  them widely usable as a means of payment. (4)

4
Moore on endogeneity

• Thus there is an essential difference between
  commodity or fiat money and credit money, but
  this is missed by conventional theory
• modern monetary theory has inherited an approach
  to money that was more appropriate in a world
  where money was a commodity without fully
  recognising the fundamental differences between
  commodity and credit money. (5)
• The supply of commodity money is clearly limited
  by
• new output of gold and silver
• Plus accumulated saleable or hoardable stocks
• Monetarist/neoclassical views ascribe the same to
  modern credit money

5
Moore on endogeneity

• In the quantity theory relation MVPT, there is
  an assumption that
• is something so elementary that it is almost
  never discussed, reflectively considered, or even
  noticed the assumption that there exists an
  independent supply function of money. (7)
• This is feasible in a solely commodity or fiat
  money system. With a system in which money is
  commodities or fiat debt of the government,
  it is easy to envision an independent supply of
  money function, conceptually distinct from the
  demand for money function. (7-8)
• But in a credit money system, the supply of
  credit adjusts to the demands of the financial
  and productive systems.

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Moore on endogeneity

• One essential difference between commodity
  gold/silver or fiat coins and notes money and
  credit money is
• Because commodity money is a material thing
  rather than a financial claim, it is an asset to
  its holder but a liability to no-one. Thus, the
  quantity of commodity money in existence denotes
  nothing about the outstanding volume of credit.
  (13)
• On the other hand, Since the supply of credit
  money is furnished by the extension of credit
  and hence debt, the supply schedule is no
  longer independent of demand the stock of bank
  money is completely determined by borrowers
  demands for credit. (13-14)
• So whats wrong with the quantity theory equation?

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Endogenous money Macro

• Quantity Equation a truism

But...
These 3 are givens
Price level
This is just a ratio derived from the other three
numbers
Output
Stock of money

• Exogenous money (Friedman) argues V stable
• Endogenous money argues V variable
• Statistics support Endogenous money
• V highly volatile, and rises during
  booms/deregulation, falls during
  slumps/reregulation

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Endogenous money Macro

• Quantity Equation
• is flexible
• works backwards

Changes in P T (e.g., increase in wages)
force changes in money supply
Causation runs from PT to M
If M inflexible during a boom, V can rise
via financial innovations
where
money multiplier
Base money
Bank loans (M3)
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Endogenous money Macro

• Reserve Bank controls B but
• Primary role lender of last resort guarantees
  depositors funds
• If bank gets into trouble, Reserve will
• Relax (increase) m
• Expand B to suit
• The need for an elastic currency to offset
  weekly, monthly and seasonal shocks, and avert
  the resulting chaotic interest rate fluctuations
  and financial crises, was the major determining
  factor in the formation of the Federal Reserve
  System (Moore 2 540)

So causation runs backwards in the money
multiplier too
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Endogenous money the main mechanisms

• Moore argues
• Primary short term role of banks is to provide
  firms with working capital
• Primary need for additional working capital is
  new wage demands (remember Kydland Prescott on
  procyclical wages?) or material costs
• (Also later research by Fama and French)
• Debt seems to be the residual variable in
  financing decisions. Investment increases debt,
  and higher earnings tend to reduce debt. (1997)
• The source of financing most correlated with
  investment is long-term debt These correlations
  confirm the impression that debt plays a key role
  in accommodating year-by-year variation in
  investment. (1998)
• Credit expands contracts w.r.t. needs of firms

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Endogenous money the main mechanisms

• Firms face new wage/material cost/investment
  demand
• Firms extend lines of credit with banks for
  working capital/investment finance shortfalls
• Increased loans lead to increased deposits by
  recipients of expenditure
• New deposits are created after the loans, but
  balance the new indebtedness
• Central bank need to underwrite liquidity ensures
  changes to base/money multiplier (itself no
  longer monitored) accommodate additional loans
• Causation thus works
• From P and T to M (with volatile V)
• From M to m and B

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Endogenous money initial consequences

• The money supply is determined by the demands of
  the commercial sector, not by the government
• It can therefore expand and contract regardless
  of government policy
• Credit money carries with it debt obligations
  (whereas fiat or commodity money does not),
  therefore debt dynamics are an important part of
  the monetary system
• Financial behaviour of commercial sector is thus
  a crucial part of the economic system.
• Endogenous money prima facie persuasive
• But some controversies in endogenous money

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Not a homogeneous field

• Many disputes within endogenous money camp
• Definition of money (also problem for exogenous
  case)
• Origin of money (was state necessary for its
  creation, or irrelevant?)
• Degree of Horizontality is credit system
  completely flexible to desires of borrowers, or
  are their limits?
• Relation between money and credit
• How credit system works to expand during
  booms/contract during slumps
• Measurement of money
• And do these disputes matter anyway? Or are they
  just semantics?

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Vicki Chick, circa 1971

• Consider early (1971) article by Vicki Chick,
  modern Post Keynesian proponent of endogenous
  money
• Article somewhat agnostic on exogenous v.
  endogenous debate
• Ideas have developed significantly since
• Many neoclassical concepts used in paper
• Article encapsulates shared debate (between exo
  endo schools) over nature of money
• How do you define it?
• How is it created?
• Article indicates how endogenous money is a
  recent concept, how fluid economic views on money
  still are

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Vicki Chick, circa 1971

• 5 main points to article
• Definition What is money?
• Origin How did money come about?
• Reason Why does money exist?
• Impact How does money affect the real economy?
  (covered more in later lectures)
• Fragility How robust is money? (covered more in
  later lectures)

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What is money?

• Many attempted definitions
• By function money is as money doesmeans of
  payment, store of value, unit of account,
  standard of deferred payment but
• First two sides of same coin (nothing could
  serve as a means of payment that was not also a
  store of value, for things which had no value
  would not be acceptable in exchange (144)
• Store of value not seen as unique attribute of
  money Unit of account and standard of
  deferred payment seen as same thing with
  different time horizons Unit of account had
  occasionally been separate from money
• So all collapses to means of payment
• BUT belief that means of payment and store of
  value identical not shared by Marx

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What is money?

• Means of payment store of value
• Neoclassical economics sees purpose of economic
  system as consumption (Chick still influenced by
  this view in 1971)
• Marx sees market economy as dominated by desire
  of capitalists to accumulate wealth
• Accumulate! Accumulate! That is Moses and the
  prophets! (Capital I, Ch 24.3 p. 558 Progress
  Press)
• Store of value and unit of account crucial here
  what matters to capitalists is not consumption
  per se, but accumulation. Abstract unit by which
  to measure accumulation therefore vital
• Main point of Marxs analysis of money

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What is money?

• It must never be forgotten, that in capitalist
  production what matters is not the immediate
  use-value but the exchange-value, and, in
  particular, the expansion of surplus-value. This
  is the driving motive of capitalist production,
  and it is a pretty conception thatin order to
  reason away the contradictions of capitalist
  productionabstracts from its very basis and
  depicts it as a production aiming at the direct
  satisfaction of the consumption of the
  producers. (Theories of Surplus Value II, s
  17.6)
• Store of value an essential aspect of
  accumulation, therefore cannot be collapsed to
  consumption-oriented means of payment function
• Back to Chick

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What is money?

• Problem with using medium of exchange means
  of payment interchangeably as definition of
  money raises distinction between money and credit
• Trade credit a common means of payment
• But trade credit does not settle an
  accountmerely changes who is in debt to whom
• Money as payment does settle an account
• Payment is effected when the transaction is
  finally closed, the debt discharged, and no
  further contact between the parties required or
  expected. If money is proffered for goods,
  payment and exchange coincide. But if trade
  credit is offered, there must be another exchange
  later on in which the credit is extinguished by a
  transfer of money or by a reverse flow of funds.
  Only then is payment affected. (145)

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What is money?

• So money and credit must be distinguished when
• The problem is not to discover the essence of
  money but to decide on criteria for useful
  aggregation of the economys assets. Aggregation
  must be determined by what we are trying to
  explain if we wish to understand the phenomenon
  of exchange, something which takes place at a
  point of time, trade credit shares the property
  of money that within its established sphere it is
  accepted as a matter of routine, even if it is
  not demanded to hold, that is, even if it
  causes temporary balance-sheet disequilibrium.
• Making the distinction, think of implications of
  this for quantity theory approach MVPT

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What is money?

• Identity VPT/M presumes only M used for
  transactions but
• Credit (e.g., trade credit) a common means of
  payment
• Credit expands and contracts dramatically over
  trade cycle willing extension of credit during
  boom, severe contraction during slump
• From quantity equation point of view, given
  measured money stock, effect will be strong
  pro-cyclical volatility in value calculated for V
• This is result found by Kydland Prescott
• Volatility of V undermines monetarist/exogenous
  money approach
• Back to Chick

22
What is money?

• Means of payment definition raises issue of
  what in practice is the means of payment?
• General acceptability becomes important, a
  pragmatic issue
• But raises dilemma how to explain something
  going from non-money to money or v.v.?
• We can only describe what is whatever is used
  as money is defined as money. We cannot predict
  the limits to which a given monetary system can
  be pushed before the monetary asset becomes
  unacceptable. Hence it is impossible to analyse
  the breakdowns associated with hyperinflation,
  the future of a new instrument such as credit
  cards We need to know why assets become and
  remain generally acceptable (146)

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What is money?

• General acceptability has two elements
• Basic characteristics of money (durability,
  maintenance of value, ease of transportation,
  etc.)
• Confidence. (This issue better handled by Dow, so
  discussed later but an essential issue)
• Summing up
• Need to distinguish money from credit
• No appreciation yet of causal chain does money
  control credit creation or does credit creation
  control money?
• Importance of purpose of inquiry for definition
  of money credit plays obvious role when
  measuring transactions but does not when
  measuring final payment.
• Next issue considered by Chick origin of money

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Origin

• (Does it matter? reasonable argument that not
  important issue
• But beliefs re origins affect how people
  define/interpret money today)
• Two extreme positions
• Money originated in commercial exchange
• Money invented by non-market (State)
  instrumentalities
• Latter approach emphasises role of levying of
  State taxes in creation of money (Chartalism)
• Former approach emphasises importance of credit
  in commercial system
• Next argument Reason Why does money exist?

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Reason

• Chicks analysis focuses entirely on exchange
  issue
• Does not even contemplate accumulation
  perspective used by Marx
• Basic issue in transaction analysis is
  elimination of need for double coincidence of
  wants
• Useful observations on convertibility between
  different currencies
• But most useful comments here continue of
  money/credit relationbeginning of endogenous
  money appreciation

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Reason

• The expansion of credit is, of course, the usual
  way of transcending a shortage of money in the
  short run. Money is probably only important as a
  budget restraint for small, recurring purchases
  the money in ones wage packet may determine
  ones beer consumption but it is unlikely to be
  the operative restraint in the purchase of a car
  a firm may pay its wage bill out of the cash flow
  from sales, but is hardly expected to finance a
  new plant that way. (156)
• Overall impression of 1971 article
• Endogenous approach still nascent
• Many neoclassical (and therefore exogenous)
  concepts interspersed with analysis
• By way of comparison, Dows 1998 paper focuses on
  nuances within definite endogenous money
  perspective

27
Sheila Dow, circa 1998

• Chapter a contribution to Geoff Harcourts
  Second edition of the General Theory
• Overall theme how would Keynes had revised the
  GT, had he the chance?
• Dows paper now much more on nuances within
  endogenous money camp, rather than overall issue
  of whether money endogenous or exogenous
• Main themes
• What did Keynes believe?
• Role for liquidity preference
• How horizontal is the money supply?
• Passive or active role for banks?

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Keynes on money

• GT a fascinating but difficult book
• Difficulty caused by
• Extent to which Keynes had not fully escaped his
  previous neoclassical training
• Developmental nature of ideas
• Debating approach often taken by Keynesaccept
  premise used by opponent and still show that
  opponent is wrong
• All these cloud question of whether GT/Keynes
  assumed exogenous or endogenous money

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Keynes on money

• Conventional Hicksian IS-LM money supply
  exogenous
• The schedule of the marginal efficiency of
  capital depends, however, partly on the given
  factors and partly on the prospective yield of
  capital-assets of different kinds whilst the
  rate of interest depends partly on the state of
  liquidity-preference (i.e. on the liquidity
  function) and partly on the quantity of money
  measured in terms of wage-units.
• Thus we can sometimes regard our ultimate
  independent variables as consisting of (i) the
  three fundamental psychological factors, namely,
  the psychological propensity to consume, the
  psychological attitude to liquidity and the
  psychological expectation of future yield from
  capital-assets, (2) the wage-unit as determined
  by the bargains reached between employers and
  employed, and (3) the quantity of money as
  determined by the action of the central bank (GT
  246-247)

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Keynes on money

• But contrary propositions to this also given
  The amount of cash that the banking system has
  created (GT 84)
• In Chapter 15 Keynes explicitly raises the
  issue of how a change in money supply comes about
  either as a counterpart to increased income
  or by a relaxation of the conditions of credit
  by the banking system GT 200 (63)
• It will, therefore, be safe for us to take the
  latter case as typical. A change in M can be
  assumed to operate by changing r, and a change in
  r will lead to a new equilibrium partly by
  changing M2 and partly by changing Y and
  therefore M1. The division of the increment of
  cash between M1 and M2 in the new position of
  equilibrium will depend on the responses of
  investment to a reduction in the rate of interest
  and of income to an increase in investment. (GT
  200-201)

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Keynes on money

• So Keynes of the General Theory (1936) appears
  midway between the argument that the State
  controls the creation of money, and that the
  banking system does
• Keynes 1937 rather differentnext lecture
• Dow argues significant structural changes to
  banking since Keyness time that amplify
  endogenous position
• Progression through the stages of banking
  evolution can be characterised by the increasing
  capacity of the banking system to create credit.
  (68)
• (1) Commodity Money (2) Fiat Money (3)
  Fractional banking
• Before stage four (circa Keynes) banks have
  been able to increase the bank multiplier, and
  the speed with which the multiplier operates but
  the multiple is still constrained by a given
  volume of bank reserves (68)

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Evolution of Banking

• Stage 4 the central bank accepts the role of
  lender-of-last-resort in order to maintain
  confidence in the banking system. Now the banks
  are no longer constrained by a given stock of
  reserves. They are still subject to reserve
  requirements, and the central bank can influence
  the demand for reserves by manipulating short
  term interest rates. But if the banks are
  prepared to pay the required interest rate to
  borrow reserves, then there is no limit on their
  credit creation. (68)
• Limit on their credit creation the essential
  point of the endogenous money case there is no
  limit if some part of the banking system keeps
  zero reserves.
• Stage 5 Liability management

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Evolution of Banking

• liability management. Banks now more actively
  sought out lending opportunities, taking care of
  deposit funding by competing over deposit rates
  and by making increased recourse to the wholesale
  market. (68)
• This period can be seen as close to the modern
  endogenous-money account, but Dow cautions that
• even then, banks could not be said to have been
  passive, in that they themselves were creating
  much of the credit demand by opening up
  speculative opportunities in the wholesale
  market.
• Further, attempts by monetary authorities to
  curtail the growth of credit, if anything,
  further fuelled the process the massive growth
  in the Eurodollar market can be seen to have
  resulted in large part from attempts to evade
  monetary control in Britain and the USA. (68-69)

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Evolution of Banking

• Stage six securitizationbundling loans to
  create marketable securities with income streams
  generated by the repayments. Also further
  disintermediationbanks withdrew from lending in
  favour of the securities markets (69)
• Stage seven market diffusionThe divide
  between banks and non-banks has been eroded by
  deregulation, as well as by market forces. (69)
• Thus, countering the disintermediation process
  of stage six, we now have the possibility of the
  liabilities of a wider range of institutions
  becoming so liquid as to be treated as money, so
  we need to consider their credit-creation process
  as well. (69)
• Next issue how tenable is the extreme Post
  Keynesian horizontalist position that the banking
  system is completely passive and just supplies as
  much credit as the economy wants?

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Passive Banking?

• Moores position known as Horizontalism
• Supply of credit by banks unlimited at going
  interest rates (short-term set by government,
  longer term partly market-affected)
• Implies banks passively supply the credit desired
  by corporations/private borrowers
• Dow argues for some role of banks in setting
  supply
• Not complete independence of supply from demand,
  but some control over terms and some limits

36
Passive Banking?

• The supply of credit, and thereby of money,
  has become more endogenous over the last few
  decades. But the private sector is not
  homogeneous there is no necessary reason for the
  banks (or credit-creators) to accommodate all
  demand at the market interest rate. (69-70)
• Criticises Moores emphasis of role of lines of
  credit in making supply elastic with statistics
• in the UK, for example, from 1984 to 1992, the
  proportion of overdrafts of total lending had
  fallen from 22 per cent to 14 per cent the
  evidence suggests that these, like the volume of
  credit as such, may also be rationed. (70)

37
Passive Banking?

• Essential qualification of Moores position
• Banks may limit credit creation in some economic
  circumstances
• Willingness to lend may collapse during a slump
• Qualification doesnt alter endogeneity per se
  just gives banks role in determination of credit
  creation process.
• Banks/financial institutions as active players in
  endogeneity, rather than passive
• Implies further pro-cyclical, cycle-leading role
  for credit
• Financial institutions may help acceleratie
  expansion of credit during a boom, accelerate its
  collapse during a slump.

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Liquidity Preference and Endogenous Money

• Liquidity preference may be characterised as a
  preference for short-term over long-term assets.
  (74)
• Concept is feasible with completely
  demand-determined money supply but Dow argues
  for banks to have a role in setting supply w.r.t.
  their own lending preferences
• Not only are banks (and thereby the monetary
  authorities) given some control over the volume
  of credit but the theory of liquidity
  preference has been extended in a way Keynes only
  hinted at in 1937. (75)
• Modelled clumsily by a series of diagrams

39
Liquidity Preference and Endogenous Money

• The limitations of a diagrammatic
  representation of a non-deterministic organic
  process become very clear. This framework is
  being offered here as an aid to thought, but it
  can only cope with one phase of the process, not
  with the feedbacks. (74)
• Dynamic models are needed to represent feedback
  effects introduced in last 2-3 lectures in the
  subject
• Basic impact of Dows framework is to reintroduce
  notion of a credit institutions having some
  active role in setting supply of credit and money
• The volume of credit is thus shown to be jointly
  determined by the central bank, the banks and the
  non-bank public. (78)

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Next lecture

• Discussion of alternative but complementary
  perspective the Circuitist School of France and
  Italy
• There is economics outside the USA and England!