Market Monetarism and Endogenous Money?

Yesterday, I was interviewed by  Erin Ade for the show Boom Bust. She asked me, among things, whether I believed money was endogenously created. If so, was my belief consistent with Market Monetarism? My answer was that inside money creation--money created by banks and other financial firms--is endogenous, but the Fed shapes in an important way the macroeconomic environment in which money gets created. Consequently, the Fed influences the creation of inside money. So yes, I believe endogenous money is consistent with Market Monetarist views.

To further unpack this idea, I want bring up a point I have repeatedly made here: open market operations (OMOs) and helicopter drops will only spur aggregate demand growth if they are expected to be permanent.¹ This idea is not original to Market Monetarists and has been made by others including Paul Krugman, Michael Woodford, and  Alan Auerback and Maurice Obstfeld. Market Monetarists have been advocating a NGDP level target (NGDPLT) over the past five years for this very reason. It implies a commitment to permanently increase the monetary base, if needed.²

So why exactly are permanent injections so important and how does this relate to endogenous money creation? From a monetarist perspective, the permanent expansion of the monetary base will lead to permanently higher nominal incomes in the future. Given there is a negative output gap, the expectation of higher future nominal income from such an injection should also create expectations of higher real economic growth. This belief should lead households and firms to increase their spending today. In the process, asset prices rise, risk premiums fall, and financial intermediation increases. From a New Keynesian perspective, the higher future price level implied by the permanent injection would result a temporary bout of higher-than-normal inflation that would lower real interest rates down to their market clearing level. Once that happened the increased spending, lower risk premiums, and increased financial intermediation would occur.

Now let's expand on that last point. The permanent monetary base increase will lead to increased financial intermedation. For example, banks will start providing more loans as the improved economic outlook makes households and firms appear as better credit risks. Likewise households and firms will start demanding more credit. All of this leads to the creation of financial firm liabilities that function as money. In short, a permanent increase in the monetary base will lead to more inside money creation.

Below is a figure that tries to reflect this story. It shows the central bank (CB) doing a permanent monetary base injection that affects the expected path of monetary policy. These injections are exogenously determined by the central bank as it decides where it wants the economy to go in terms of inflation, the output gap, or in my ideal world NGDP. These exogenous changes in the path of monetary policy alter economic expectations and therefore shape how inside money is endogenously created.

Now some may object that during normal times the monetary base is endogenously determined for interest rate-targeting central banks. After all, for a given interest rate target central banks will accommodate changes in the demand for reserves. This is true in the short run, but not far beyond that. As noted above, central banks ultimately care about inflation and output gaps and consequently will adjust interest rates over time to hit their inflation and output gap objectives. Such changes in interest rates mean changes in the supply of bank reserves. Stated differently, it implies a different degree of policy accommodation to changes in the demand for bank reserves. These changes, then, mean the central bank is exogenously changing the path of the monetary base.

Let me illustrates this point with two extreme cases. Consider the implicit Taylor rule for the United States during the Great Inflation of the 1970s and the Taylor Rule for the ECB over the past few years. The parameters on the inflation term (which measure to degree to which policymakers respond to changes in inflation) were very different. For the United States the parameter was very low and at the ECB it has been very high. These different inflation parameters were exogenous policy choices and determined the very different paths of the monetary base for these two economies. So even with an interest rate-targeting regime, the path of the monetary base is ultimately determined by the central bank.

Now lets return to the original question posed by Erin Ade. Market Monetarism, in my view, is consistent with inside money creation being endogenous. Because of this understanding, we believe the Fed should create a macroeconomic environment that is conducive to financial firms creating the optimal amount of money. We believe a NGDPLT does just that since it is stabilizing, by definition, the product of the money supply and money velocity.

Update: This statement is not quite right: "These changes, then, mean the central bank is exogenously changing the path of the monetary base." The central bank does independently change the path of the monetary base as it responds to changes in the economy, but this path change is itself endogenous to its central bank's ultimate target. All variables other than the target variable are ultimately endogenously determined. The exogenously chosen nominal target variable, however, does constrain the endogeneity of all other nominal variables. Or, as Francis Coppola nicely put it, "Endogeneity itself is exogenously constrained."

P.S. Erin Ade interviewed Scott Sumner too on the program. Here is the link for the full program.

¹Also, it is assumed the monetary base injection will not be sterilized by further increases in IOR.

²It is likely that a NGDPLT, through its influence on expectations, will raises the velocity of the monetary base. In this case, the permanent increase in the monetary base will be small. Nonetheless, it is the threat to permanently change the monetary base as much as needed that is the key catalyst here.