lecture_02_debates in endogenous money 2006

8/9/2019 Lecture_02_Debates in Endogenous Money 2006

1/42

Financial Economics Lecture Eight

Theory of endogenous money


2/42

Last Week

The conventional deposits cause loans view

Statistics tell the opposite story Basic mechanics of loans cause deposits creation of

credit money

This week:

Early theorists of loans cause deposits, endogenousmoney

Development of theory over time


3/42


4/42

Moore on endogeneity

Changes in wages and employment largely determine the

demand for bank loans, which in turn determine the rateof growth of the money stock. Central banks have no alternative but to accept this

course of events, their only option being to vary theshort-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 borrowersdemand. (Moore [1] : 3-4)

In a nutshell The supply of money & credit is determined by the

demand for money & credit. There is no independentsupply curve as in standard micro theory

All the state can do is affect the price of credit (the

interest rate).


5/42


Conventional economic theory springs from the facts that

Once, money was gold and silver coin Today, bank notes are state-issued legal tender

Conventional theory treats the latter as just a variant ofthe former

Endogenous money theorists look instead at the inventionof credit, when negotiable notes were first issued byprivate 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 owninstruments of indebtedness. The payability of bankIOUs to the bearer rather than to a named individualmade them widely usable as a means of payment. (4)


6/42


Thus there is an essential difference between commodity

or fiat money and credit money, but this is missed byconventional theory:

modern monetary theory has inherited an approach tomoney that was more appropriate in a world where

money was a commodity without fully recognising thefundamental differences between commodity andcredit 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 tomodern credit money:


7/42


8/42


One essential difference between commodity[gold/silver] or fiat [coins and notes] money and creditmoney is

Because commodity money is a material thing ratherthan a financial claim, it is an asset to its holder but a

liability to no-one. Thus, the quantity of commoditymoney in existence denotes nothing about theoutstanding volume of credit. (13)

On the other hand, Since the supply of credit moneyis furnished by the extension of credit [and henceand hencedebtdebt], the supply schedule is no longer independent ofdemand the stock of bank money is completelydetermined by borrowers demands for credit. (13-14)

So whats wrong with the quantity theory equation?


9/42

Endogenous money: Macro

Quantity Equation a truism

P TV

M

|

But... These 3 are givens:Price level

Output

Stock of money

This is just a ratioderived from theother three numbers

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


10/42


Quantity Equation

is flexible works backwards

VP T

M

!

If M inflexibleduring a boom,V can rise via

financial innovations

Changes in P & T (e.g.,increase in wages)forcechanges in moneysupply Causation runs

from P&T to M:

where M m B!

Bank loans (M3)money

multiplier

Base money


11/42


Reserve Bank controls B; but

Primary role lender of last resort: guaranteesdepositors 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 theresulting chaotic interest rate fluctuations andfinancial crises, was the major determining factor

in the formation of the Federal Reserve System(Moore [2]: 540)

So causation runsbackwards in the

money multiplier too:

M m B!


12/42

Endogenous money: the main mechanisms

Moore argues

Primary short term role of banks is to provide firmswith working capital Primary need for additional working capital is new wage

demands (remember Kydland & Prescott on procyclicalwages?) 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 withinvestment is long-term debt Thesecorrelations confirm the impression that debtplays a key role in accommodating year-by-yearvariation in investment. (1998)

Credit expands & contracts w.r.t. needs of firms


13/42

Endogenous money: the main mechanisms

Firms face new wage/material cost/investment demand

Firms extend lines of credit with banks for workingcapital/investment finance shortfalls

Increased loans lead to increased deposits by recipientsof expenditure

New deposits are created after the loans, but balancethe new indebtedness

Central bank need to underwrite liquidity ensures changesto 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


14/42

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 debtdynamics are an important part of the monetary system

Financial behaviour of commercial sector is thus a crucialpart of the economic system.

Endogenous money prima facie persuasive But some controversies in endogenous money


15/42

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 duringbooms/contract during slumps

Measurement of money And do these disputes matter anyway? Or are they

just semantics?


16/42

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


17/42

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)


18/42

What is money?

Many attempted definitions

By function: money is as money doesmeans ofpayment, store of value, unit of account, standard ofdeferred 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 beacceptable in exchange (144)

Store of value not seen as unique attribute ofmoney; Unit of account and standard of deferredpayment seen as same thing with different timehorizons; Unit of account had occasionally beenseparate from money

So all collapses to means of payment BUT belief that means of payment and store of

value identical not shared by Marx


19/42

What is money?

Means of payment & store of value

Neoclassical economics sees purpose of economicsystem as consumption (Chick still influenced by thisview 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 [ProgressPress])

Store of value and unit of account crucial here:what matters to capitalists is not consumptionwhat matters to capitalists is not consumptionper se, but accumulationper se, but accumulation. Abstract unit by whichto measure accumulation therefore vital

Main point of Marxs analysis of money:


20/42

What is money?

It must never be forgotten, that in capitalist production

what matters is not the immediate use-value but theexchange-value, and, in particular, the expansion ofsurplus-value. This is the driving motive of capitalistproduction, and it is a pretty conception thatin order toreason away the contradictions of capitalist productionabstracts from its very basis and depicts it as aproduction aiming at the direct satisfaction of theconsumption of the producers. (Theories of SurplusValue II, s 17.6)

Store of value an essential aspect of accumulation,therefore cannot be collapsed to consumption-orientedmeans of payment function

Back to Chick


21/42

What is money?

Problem with using medium of exchange & means of

payment interchangeably as definition of money raisesdistinction 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 contactbetween the parties required or expected. Ifmoney is proffered for goods, payment andexchange coincide. But if trade credit is offered,there must be another exchange later on in whichthe credit is extinguished by a transfer of moneyor by a reverse flow of funds. Only then is paymentaffected. (145)


22/42

What is money?

So money and credit must be distinguished when

The problem is not to discover the essence of moneybut to decide on criteria for useful aggregation of theeconomys assets. Aggregation must be determined bywhat we are trying to explain: if we wish to understand

the phenomenon of exchange, something which takesplace at a point of time, trade credit shares theproperty of money that within its established sphereit is accepted as a matter of routine, even if it is notdemanded to hold, that is, even if it causes temporary

balance-sheet disequilibrium. Making the distinction, think of implications of this for

quantity theory approach MV=PT


23/42

What is money?

Identity V=PT/M presumes only M used for transactions;

but Credit (e.g., trade credit) a common means of payment;

Credit expands and contracts dramatically over tradecycle: 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-cyclicalvolatility in value calculated for V

This is result found by Kydland & Prescott Volatility of V undermines monetarist/exogenous moneyapproach

Back to Chick


24/42

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 usedas money is defined as money. We cannot predictthe limits to which a given monetary system canbe pushed before the monetary asset becomesunacceptable. Hence it is impossible to analysethe breakdowns associated with hyperinflation,the future of a new instrument such as creditcards We need to know why assets become andremain generally acceptable (146)


25/42

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, sodiscussed 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 creationcontrol money?

Importance of purpose of inquiry for definition ofmoney: credit plays obvious role when measuringtransactions but does not when measuring finalpayment.

Next issue considered by Chick: origin of money


26/42

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?


27/42

Reason

Chicks analysis focuses entirely on exchange issue

Does not even contemplate accumulation perspectiveused by Marx

Basic issue in transaction analysis is elimination of needfor double coincidence of wants

Useful observations on convertibility between differentcurrencies

But most useful comments here continue of money/creditrelationbeginning of endogenous money appreciation:


28/42

Reason

The expansion of credit is, of course, the usual way of

transcending a shortage of money in the short run. Moneyis probably only important as a budget restraint for small,recurring purchases: the money in ones wage packet maydetermine ones beer consumption but it is unlikely to bethe operative restraint in the purchase of a car; a firm

may pay its wage bill out of the cash flow from sales, butis 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


29/42

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 ofwhether 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?


30/42

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 Keynesacceptpremise used by opponent and still show that opponentis wrong

All these cloud question of whether GT/Keynes assumed

exogenous or endogenous money


31/42

Keynes on money

Conventional Hicksian IS-LM: money supply exogenous

The schedule of the marginal efficiency of capitaldepends, however, partly on the given factors and partlyon the prospective yield of capital-assets of differentkinds; whilst the rate of interest depends partly on thestate of liquidity-preference (i.e. on the liquidityfunction) and partly on the quantity of money measured interms of wage-units.

Thus we can sometimes regard our ultimate independentvariables as consisting of (i) the three fundamentalpsychological factors, namely, the psychological

propensity to consume, the psychological attitude toliquidity and the psychological expectation of future yieldfrom capital-assets, (2) the wage-unit as determined bythe bargains reached between employers and employed,and (3) the quantity of money as determined by thethe quantity of money as determined by theaction of the central bankaction of the central bank (GT 246-247)


32/42


33/42

Keynes on money

So Keynes of the General Theory (1936) appears midway

between the argument that the State controls thecreation of money, and that the banking system does Keynes 1937 rather differentnext lecture

Dow argues significant structural changes to banking sinceKeyness time that amplify endogenous position:

Progression through the stages [of banking evolution]can be characterised by the increasing capacity of thebanking system to create credit. (68)

(1) Commodity Money; (2) Fiat Money; (3) Fractionalbanking

Before stage four (circa Keynes): banks have been ableto increase the bank multiplier, and the speed withwhich the multiplier operates; but the multiple is stillconstrained by a given volume of bank reserves (68)


34/42

Evolution of Banking

Stage 4: the central bank accepts the role of lender-of-

last-resort in order to maintain confidence in the bankingsystem. Now the banks are no longer constrained by agiven stock of reserves. They are still subject to reserverequirements, and the central bank can influence thedemand for reserves by manipulating [short term]interest rates. But if the banks are prepared to pay therequired interest rate to borrow reserves, then there isno limit on their credit creation. (68)

Limit on their credit creation the essential point of

the endogenous money case: there is no limit if somepart of the banking system keeps zero reserves.

Stage 5: Liability management


35/42

Evolution of Banking

liability management. Banks now more actively sought

out lending opportunities, taking care of deposit fundingby competing over deposit rates and by making increasedrecourse to the wholesale market. (68)

This period can be seen as close to the modernendogenous-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 creditdemand by opening up speculative opportunities in thewholesale market.

Further, attempts by monetary authorities to curtail the

growth of credit, if anything, further fuelled theprocess: the massive growth in the Eurodollar market canbe seen to have resulted in large part from attempts toevade monetary control in Britain and the USA. (68-69)


36/42


37/42

Passive Banking?

Moores position known as Horizontalism

Supply of credit by banks unlimited at going interestrates (short-term set by government, longer termpartly 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


38/42

Passive Banking?

[T]he supply of credit, and thereby of money, has

become more endogenous over the last few decades. Butthe private sector is not homogeneous; there is nonecessary reason for the banks (or credit-creators) toaccommodate all demand at the market interest rate.(69-70)

Criticises Moores emphasis of role of lines of credit inmaking supply elastic with statistics:

in the UK, for example, from 1984 to 1992, theproportion [of overdrafts of total lending] had fallen

from 22 per cent to 14 per cent the evidencesuggests that these, like the volume of credit as such,may also be rationed. (70)


39/42

Passive Banking?

Essential qualification of Moores position

Banks may limit credit creation in some economiccircumstances

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 itscollapse during a slump.


40/42

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 tohave a role in setting supply w.r.t. their own lendingpreferences

[N]ot only are banks (and thereby the monetaryauthorities) given some control over the volume ofcredit but the theory of liquidity preference hasbeen extended in a way Keynes only hinted at in

1937. (75) Modelled clumsily by a series of diagrams


41/42


42/42

Next lecture

Discussion of alternative but complementary perspective:

the Circuitist School of France and Italy There is economics outside the USA and England!

lecture_02_debates in endogenous money 2006

Documents