Anyways, I came across the idea of endogenous money. Most people with a intro to intermediate level of econ knowledge know endogenous means it is something determined. If you are using a model to figure out how much money you need to make a month to live (needed income = rent + food + electric bill + phone), "needed income" would be the endogenous thing- it is the variable you are trying to figure out.
So endogenous money implies it is not known, not a given. This is contrary to monetary policy back in the 1980's when the money supply was not only supposed to be known, but to be targeted.
Thus two stories emerge (one of my professors assigned a reading that was very helpful in thinking about the historical roots of this stuff- the reading is called So far from Ricardo, So close to Wicksell by Axel Leijonhufvud).
The first story is the story of Ricardo and the Monetarists-the central bank expands the monetary base through open market operations and thus expands the money supply in proportion to the money multiplier. This story seems to fit the Ricardo/Monetarist view of the money supply- that the money supply can be controlled- something exogenous.
Let's look at this in a bit of detail. (A point one should try to conceptualize when thinking about central banks (CB) is that a central bank is like a bank's bank. Banks have checking accounts at central banks. Those checking accounts are referred to as "reserves".)
The monetary base is made up of currency and reserves. The central bank can increase or decrease the money base if they engage in open market operations; they either buy (expansionary) or sell (contractionary) US bonds. So if the CB buys a $50 bond from a dealer, either they get $50 in cash (increasing Currency) or the bank of that bond holder gets $50 added to their checking account at the CB (increasing Reserves). Discount loans operate in a similar fashion- loans to banks are credited to the bank's checking account at the CB. In other words, the CB increases the bank's reserves and thus increases the monetary base.
The money supply is made up of currency and deposits. Banks create money in this story by accepting deposits and loaning them out. So for example, if I deposited $1000 into my bank, it would keep a certain amount of it, and loan the rest back out in the form of a loan, say $800. So the money supply increased by $800.
Banks create money but the central bank can control how much money is created through different channels; open market operations, the discount rate, reserve requirements, and interest on reserves.
Expansionary open market operations and the discount rate can potentially increase the money supply if the money multiplier is more than one. The reserve-deposit ratio is the amount of money banks must keep out of the deposits that they take in. In my example above the R/D ratio was $200 out of $1000 = .2 Thus, if the reserve ratio is higher, the amount of lending (money creation) banks can do will be constrained.
The professor who distracted me notes that the traditional relationship between deposits and reserves is backwards; deposits do not create loans, loans create deposits. (I don't remember if Wray mentions the relevance of credit in his piece as it is quite long but I see the extension of credit- the bank accepting an "IOU" from a business or person- as a clear connection to Wicksell and the argument for endogenous money).
What does this mean? It means a bank makes a loan to a business (or person I suppose too) by creating deposits for that business or person to use. The question you may be thinking, and I asked myself next is, "well, where do the deposits come from?". The deposits are debited or taken away from the bank's reserves (or checking account at the central bank).
Bank agrees to make $100 loan to business --> Bank takes $100 out of their checking account (reserves) at central bank --> Bank now has $100 of new deposits the business can use
Reserves (not a part of money supply) transform into deposits (are a part of the money supply)
This chain made me think, well if the reserves are just transforming into deposits and the central bank can control the reserves, why can't the CB still control the money supply? To that question, I think there are a few answers:
If banks have excess reserves, additional reserves via open market operations won't encourage them to lend (think of the little effect of the huge push of the monetary base during the Great Recession, no one wanted to lend for fear of becoming insolvent!). If banks have excess reserves, they won't need to approach the discount window. If banks have excess reserves then the reserve requirement doesn't mean anything. If the CB's tools to control the money supply are neutralized, then the money supply can not be determined by the monetary base. The money supply becomes a function of money demand and we are in a world closer to Wicksell, a world of credit and endogenous money:
References: Ball, L. (2009). Money, Banking, and Financial Markets.
Leijonhufvud, A. "So far from Ricardo, So close to Wicksell"
Wray, R.L. (2012). "Krugman vs. Minsky: Who Should you Bank on when it Comes to Banking?"
Also, as one of my professors mentioned in class, how is the CB targeting the interest rate if the money supply is endogenous? Am I right in thinking the liquidity preference theory falls apart without an exogenous money supply? What types of models are they using?
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