Wednesday, November 21, 2012

Let's clear up a few things on the exogenous/endogenous money post

This came up in a couple places but a comment by Unlearningecon offers an opportunity to focus in on it. He writes:

"Reserves are just another cost decision, along with staff, other inputs, etc. The availability of them does not enter into a bank's lending decisions, which is done purely on a bookkeeping basis. At the end of some time period, a bank will settle its reserve decisions, as with any other cost. The price of reserves can be altered to make banks lend less/increase the interest rates, but this is only in a similar way that some other 'supply shock' might."

I think some of this is good and some of this isn't. If by "endogenous money" you just mean "loans create deposits", that's certainly correct [supply and demand simultaneously determine equilibrium so I'd add "deposits create loans" too, but no need to get into that because I don't challenge the "loans create deposits" point].

But a lot of people mean a lot more than that. A lot of people mean that the level of reserves is endogenous to the rest of the banking system - that it's just a residual that pops out of the loan and deposit creation decisions, given an interest rate decision by the central bank.

This point - that the banking system generates a particular level of reserves - is what I challenge. The central bank does exogenously create and destroy reserves every day. This is the exogenous policy lever.

Another point of clarification: if you think "endogenous money" means that the central bank targets interst rates, that's fine but I don't think anyone disagrees with that point. My point is, they don't "set" an interest rate and then reserves become whatever level is consistent with that interst rate and the decisions of the banking system. No - the central bank has an interest rate target they are interested in, and then they "set" reserves by buying and selling bonds (or through other institutions in other countries) so that the interest rate they want falls out the other end.

It doesn't have to work this way, of course. This is all based on institutional set ups. You could have the causality running from interest rates, through the banking system, to reserves if you wanted. That would be a discount window approach. An interest rate is set and the Fed takes all comers. Base money is endogenous. We used to do that. But now we primarily work through open market operations and causality runs the other way. Reserves get shuffled and a desired interest rate pops out the other end.

When most Fed policy starts taking place at the discount window again rather than the open market desk, we can talk about the strong version of endogenous money again (i.e. - not the weaker "loans create deposits" version that I think is fairly non-controversial when we get down to it).


  1. I'm not sure if really talking about the same thing as most monetary economists, though.

    When they talk about endogeneity and exogeneity, they are describing the ability of the policy maker to decide on the value of some economic variable.

    Imagine that you have a function, y = f(x), and that this function is invertible so that you can also write x = g(y).

    Here, you can either set x in the first case, and then take y as given since y is dependent on x, or set y in the second case and take x as give.

    What you can't do, because of the functional relationship between the two, is set both x and y. It's one or the other.

    In the same way, first order conditions imply that either the money supply or the interest rate can be set exogenously (that is, by the central bank), but not both. You can't hit an interest rate target and a monetary aggregate target at the same time.

    Of course, money enters the system via OMP, and no one is disputing or debating that. But if you want to say that this is "endogenous money", then you're using a different language to everyone else.

    1. This is not how everyone talks. It's not simply that we have interest rate rules and not monetary policy rules. Everyone agrees on that (again - Keynes wanted that and Keynes is often noted by post-Keynesians to be an exogenous money guy). People talk about banks deciding how much reserves they want based on the interest rate. They talk about how the central bank is passive or "accomodative" - not actively (exogenously) setting the level of reserves to achieve a particular goal.

      Ultimately there's a big middle ground that we all agree on. You say that middle ground is all endogenous money people are claiming - this doesn't seem to be the case to me, and that middle ground we agree on certainly isn't sufficient for tossing the money multiplier (which is definitely a claim of endogenous money people).

      I don't know these issues in detail, but I'm starting to sympathize with Krugman vis a vis Keen.

    2. Who are the "endogenous money people"?

      I'm talking about the standard, mainstream monetary economics literature--nothing to do with post Keynesianism or any other heterodox school.

      Money is endogenous because interest rates are exogenous. Think about it like an economist: How does the representative investor allocate his savings between money and bonds? He solves an optimization problem. Bonds offer a fixed nominal return, and money possesses liquidity properties that bonds lack. In equilibrium, the two have to cancel out, so that the marginal return on bonds is exactly equal to the marginal (non-percuniary) return on money, and the investor is indifferent between the two.

    3. vimothy -
      I'm fine with that second paragraph as I am with mainstream talk about this. But the rest of your second paragraph after your first sentence doesn't do much to validate the first sentence. I could as easily exhort to you - think about it like an economist: How are interest rates determined? Interest rates, like all prices, are determined with an optimization process. Prices are set to equilibrate the supply and demand for both bonds and money. These quantities are equal when prices are set equal to the marginal benefit of these assets.

      Have a demonstrated that interest rates are endogenous? Of course not. I've just demonstrated that prices and quantities are simultaneously determined. If you assume price competition, of course quantities look exogenous. If you assume quantity competition, of course prices look exogenous.

      What is set exogenously here? Reserves and interest rates. They HAVE to be set simultaneously of course. A particular reserve level implies an interest rate just as a particular interest rate implies a reserve level. But it's all set exogenously. Broader monetary aggregates are endogenous to this exogenous decision. This is what most mainstream folks have in mind - broad monetary aggregates can't be targeted and we exogenously decide reserves to achieve a target interest rate. I agree with this and insofar as this is what you mean by "endogenous money" I agree with endogenous money.

      But we have been talking about heterodox usage of the term. And they make claims like the money multiplier doesn't make sense or that the central bank doesn't exogenously set reserve levels. This stuff is a lot more problematic.

    4. As an example of mainstream economists discussing the endogeneity of the money supply under an IR target, here's the first sentence from a famous paper by probably the most influential academic monetary economist in the world, Mike Woodford:

      "It is shown that the price level remains determinate even in the case of two kinds of radical money supply endogeneity--an interest rate peg by the central bank, and a "free banking regime"--that are supposed to imply loss of control of the price level."

      --"Price level determinacy without control of a monetary aggregate" (1995)

    5. "How are interest rates determined? Interest rates, like all prices, are determined with an optimization process. Prices are set to equilibrate the supply and demand for both bonds and money."

      That's more or less what I just wrote--which is exactly the logic that tells you that if the interest rate is set by the central bank, the supply of money is determined by the optimal plans of investors.

      "Have a demonstrated that interest rates are endogenous? Of course not."

      What you have demonstrated is that the two are co-determined, so that if one is pegged by the authorities, the other cannot possibly be pegged. If the authorities chose to fix the return on bonds, then the quantity of money must adjust in order to bring the system to equilibrium. On the other hand, if the quantity of money is fixed, then the return on bonds must do likewise.

    6. The problem with this whole discussion is defining what "exogeneous" means.

      In terms of feedback theory we have a dependent variable. In control that's sometimes called the "plant transfer function". And we have an independent variable which is used to control the dependent variable through a feedback loop. Interest rate targeting is similar. The independent variables are the amount of outstanding reserves and the regulations such as reserve requirements and capital requirements. The dependent variable is the interest rate. This "feedback loop" through the investment market and expectations about it doesn't include all of the economy, only a part of it.

      Vimothy's point is that within that part we should call the independent variables "exogeneous" and the dependent variable, the discount rate, "endogeneous". From the point-of-view of someone looking at a larger picture though it may make more sense to call both "exogeneous", that's Daniel's point. I'm sympathetic to both views, but I prefer Vimothy's because I think the issue is simple enough that we can talk in his terms, even though it makes other things more complicated. It's also appropriate because money creation has consequences by itself, no matter if it changes the interest rate or not.

    7. re: "The problem with this whole discussion is defining what "exogeneous" means."

      I agree - I started the first post being very equivocating because I don't think the meaning of these words is very clear in this discussion - it's short hand for a lot of different ideas, some of which are fine and some of which are more eccentric.

      I largely agree with vimothy too (although I think calling it endogenous confuses the issue a little - I agree with the analysis). My issue in the first post was with the heterodox ideas that get bundled up into this phrase "endogenous money" like trashing the money multiplier. I do agree this is different from what vimothy is bringing up and I should have been more clear at bringing over the focus on heterodox views to this thread.

    8. I'll side with Vimothy on this one.

      The Fed has historically set an interest rate and let the market decide the quantity of reserves. It was different during the monetarist experiment between 1978 and 1981. The Fed chose the quantity of reserves and left the interest rate to the market. That's one reason the Fed stopped targeting reserves - interest rates were too volatile. It's impossible to control both.

      The same reasoning applies to setting a currency peg in international markets. You can either control your currency's exchange rate or the domestic price level, but you can't control both. Says Krugman:

      "The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain – or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today)."

      Notice I didn't say anything about endogenous/exogenous. Not a big fan of those words, and you haven't defined them anyways. But if you see nothing wrong with the above points I've written then I'll go merrily on my way.

    9. Now let me get something straight - when you all say that the Fed does not "decide the quantity of reserves", what you mean is that the Fed doesn't target some level of reserves that they're interested in or target some monetary growth rate. That's what the deal was between 78 and 81.

      But not targeting reserves as magnitude of interest is very different - it seems to me - from letting the quantity of reserves be determine by the market. It doesn't do that. It adjusts the level of reserves, in the interest of targeting an interest rate.

      You can keep the interest rate stable and targeted or you can keep reserves stable and targeted. But saying you don't care about targeting reserves seems different from saying that they're endogenous.

      Think about it with the deficit and full employment in the context of an old Keynesian way of looking at things. You don't really care what the level of the deficit is (just like the Fed doesn't care what base money is). You care about employment, and you'll move the deficit around to hit an employment target. The fact that you're not targeting the deficit doesn't make it endogenous, though. You wouldn't say "the employment level is exogenous and the deficit is whatever emerges endogenously to hit our target employment level". No - it is the deficit that you move exogenously to hit the target. There's nothing "endogenous" or "passive" about the deficit at all. It is thoroughly exogenous.

    10. re: "Notice I didn't say anything about endogenous/exogenous. Not a big fan of those words, and you haven't defined them anyways. But if you see nothing wrong with the above points I've written then I'll go merrily on my way."

      I agree completely on getting past this endogenous/exogenous stuff. I think it confuses the issue. I agree with everything you said about exchange rates too.

      The problem with "endogenous money" talk by heterodox economists is that it allows them to slip in bad claims like that the money multiplier is a worthless concept by associating it with very reasonable assertions that mainstream economists accept like the substantive arguments you, vimothy, and Current have been making.

    11. From the point of view of economic theory, for the most part, it's probably not very important whether the central bank targets an interest rate or a monetary aggregate. Since the two are interdependent, it's also pretty easy to frame central bank actions in terms of one or the other. So, in terms of writing intermediate textbooks and coming up with nice simple models that help us to make sense of complicated and generally quite obscure institutions, it makes a lot of sense to think of things in terms of money, which is the more intuitive and traditional way to do it.

      However, interest rate targeting is what modern central banks do--or did, at any rate, until quite recently. One reason that it can be good to foreground this aspect of monetary policy is that many heterodox commenters (post Keynesian especially) think that "endogenous money" is some kind of trump card that proves that the rest of economics has got it all wrong. But endogenous money is actually pretty mundane. In order to see that it's mundane, you need to take it back to first principles. But I think that it's a better way to deal with heterodox criticism than denying something that seems obviously true.

    12. Daniel, it seems you could be concerned about the level of private debt under endogenous money in the same way you could be concerned about the level of public debt under your scenario. Especially if you only consider falling tax revenue and automatic stabilizers rather than stimulus bills.

      I haven't seen much talk on them but it seems the money multiplier might really be a simplification that really reflects capital requirements. Banks' capital rules are something of a mystery to me though. I don't even know what banks really do with deposits or not. Do they lend them or invest them?

  2. I don't see the difference. My understanding of endogenous money is just that the stock of money is endogenous to the model as opposed to exogenously set by the FOMC or similar. From that point of view, the discount window is identical to open market operations under and interest-rate targeting regime. When using the discount window, you model the response of economic actors to the interest rate and out pops the stock of money. For open-market operations to achieve the interest rate target, that means open-market operations have to respond to the interest rate target and economic actors. In other words, open-market operations are themselves endogenous and so is the money stock.

    I'm realizing this is more or less what vimothy is saying.

  3. In non-liquidity trap times a CB sets an overnight rate and will create any level of reserves that banks want to borrow at that rate. The overnight rate is normally set with a view to targeting something else - typically an inflation rate. If it is missing its target (for example: inflation is forecast as higher than the target) it will adjust interest rates appropriately , which will affect banks desire to borrow reserves at that rate and lead to adjustment to the money supply in the direction needed to hit the target.

    While in the short term money is endogenous (the banks can lend as much as they want - and the CB will comply by creating reserves ) in the medium term the CB , by using the overnight rate with reference to whatever it is targeting, will be able to exercise a great deal of control over it. It can , as it did in the early eighties, actually target a specific size or growth rate of the money supply itself - though this proved to be problematic because targeting the money supply caused velocity to jump around - hence things like inflation that factor in velocity turn out to be more sensible things to target.

    Post-Keynsians seem to simply deny reality when they assert endogenous money, unless perhaps they believe that the CB blindly does what the banks (and not the govt) demands. They also claim that the fact that the money multiplier breaks down at the zero-bound is further evidence of endogenousity, ignoring other explanations as to why this might happen.

    1. I agree with that, Basil Moore was wrong.

      In other discussions I've often compared this to the practices of internet service providers. In the very short run I control the amount of internet bandwidth I use, but over the period of a month my ISP effectively controls it by charging me a huge fee if I exceed my cap, and threatening to cut me off if I don't pay it. Similarly, in the very short run the banks themselves control the quantity of money, but over a slightly longer period the central bank controls it via the reserves, reserve ratio, capital ratio and regulatory levers.

    2. A related analogy would be an ISP who allows unlimited use for monthly fees, but if it finds that usage is too high over the month it will jack up monthly charges to bring usage back down again to a level that it targets.

  4. I think the relevant point here is that by open market operations, targeting a given interest rate, the central bank is not really acting on the quantity of reserves, but rather on the relative scarcity (and thus, price) of reserves.

    If the demand is endogenous (and it is), and the price (interest rate) is set by the central bank, there's only one supply level consistent with both the given demand and the chosen price. Thus the supply is endogenously determined by the demand and exogenously by the interest rate decision of the central bank. But there's no "quantity" decision at play in there.

    In fact there's no quantity decision at play at any point of time, because the central bank is looking at inflation and unemployment to set it's interest rate, so it does not at any point look at the quantity or set the quantity, just the relative scarcity.

    Anyway I think the entire "base money" thing is largely irrelevant because the CB can also directly manipulate base money level (e.g. QE) and use alternative policies (e.g. interest rates on excess reserves) to enforce its decisions.

    IMHO the entire point of "endogenous money" is showing very clearly that you can push on base money (i.e. quantity) as much as you wish, but if you can't move the price of money (i.e. ZLB), you won't move the broad money supply much. And worse, if your money demand curve becomes vertical, there's not much that you can do *at all*.

    1. Oh well I guess vimothy already said it all, and better than me, too. :D

  5. Rejection of the money multiplier is not just a heterodox thing:


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