Friday, March 28, 2014

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.


  1. David, I respond to Cullen here about your post (nice post BTW). I'm focusing on your use of the term "exogenous." I tell him about my previous conversation with Nick Rowe on this, and what I think is a slight difference between you and Nic. I quote Nick's comments to me regarding a previous post of yours. Could you take a look? Thanks:

    1. I took a look and made a clarifying update above. Also, that was a typo in the figure you pointed out. Suppose to show increased loans from financial intermediaries and increased credit instruments or bonds from financial markets. It has now been fixed.

  2. Dear David,

    Quite an interesting interview. I just had a small problem understanding the optimal amount of money, the system needed. I though, according to my understanding any financial system requires an inflated monetary base. Thus, interest rates would be the leading indicator, to any monetary easing. But under the same senario, NGDPLT would be the legging one ... as nominal income tend to adjust after the effect of prices took place!

    The article is really interest, but bit difficult

  3. David, can you explain what the difference is between the two arrows (in your chart), both going up to "FIRMS": one labeled "Increase loans" and the other called "Increase loans equity." Thanks.

  4. Good post David. We are on the same page. But I'm afraid you lost me in the diagram!

    1. Thanks Nick. The diagram does need more explanation and for the purposes of this post it could have been simpler. Point was to show via the flow of arrows (1) CB sets path of monetary policy, (2) this path shapes expectations about future economy, and (3) these expectations influence current endogenous money creation.

  5. David, do you think it would make sense to include any of the following in the box at right, maybe even in the structural box therein?

    • Labor share of income
    • (Real) wage trajectory
    • Dispersion of wealth

    If we assume that many/most people's expectations are based largely on the present and recent past, and income/wages are extremely salient (people see and notice them all the time), measures such as these seem like they'd be quite powerful in setting expectations. (More so than, for instance, Fed-watchers' musings about the future.)

    OTOH, those measures might not be so salient for big expectations players in the financial markets, and their moves might be the significant ones, at least short-term.

    I admit I'm grinding an axe here (extreme inequality strangles growth), but I don't think that it is (or I am) prima facie dull...

    1. Steve, I should explain the figure more but yes if you consider your list structural then it should be in there too. The idea is that forward looking households and firms see both the cyclical and structural forces--or at least their manifestation in terms of jobs, incomes, etc--that will affect where the economy goes. They make their plans accordingly. The Fed plays an important part over the business cycle forecast horizon, but the structural ones become more important over longer forecast horizons.

  6. Money was created as a good which is easy to store and which was valuable to everyone regardless of the consumer basket. Money appeared because the market needed it very much to evaluate. Now money are referred to banks, Britain Loan, insurance but this is not the primary function of it.

  7. "All variables other than the target variable are ultimately endogenously determined."

    That would make for a great recap post.

    Too much thinking on this issue is from the trees to the forest.

    A top down, robust connection between the two views is needed.

    It's an opportunity - in that endogenous money could be a subset of the exogenous view.

    I suggested something, a bit more abstract, but consistent with that here:

    1. Thanks JKH. Yes, I do think there is much more overlap that many of us initially imagined.

  8. If I extrapolate your argument into the current environment, I would interpret what you are saying as follows: consumers, banks, and firms believe the large monetary base at present is temporary. Today's NGDP growth is basically the maximum that is supportable by the amount of reserves that people believe will stay in the banking system permanently--the portion the Federal Reserve won't take back after they finish their QE program. Perhaps uncertainty about how much *is* truly permanent may also play a role. I would also interpret you are saying the following: the amount of bank lending (and thus endogenous money creation) is based primarily on expected economy-wide nominal income; to re-frame that last point: bank lending doesn't drive NGDP per se, but rather expectations of NGDP drive bank lending (at least to a substantial degree). The Federal Reserve has the power to credibly influence NGDP expectations but doesn't exercise it to the extent they should. In other words, I believe you are saying that total factor productivity, financial innovation, and animal spirits have less of an influence on the amount of bank lending than does expectations of NGDP (or perhaps it is more accurate to say that NGDP expectations drive total factor productivity etc. which in turn influence bank lending). If I understand correctly, if the Federal Reserve credibly targeted NGDP, there would never be a shortage of productive investment opportunity for whatever the level of desired savings at full employment is (without any changes to fiscal policy). Is this a fair interpretation of MM? I'm trying to wrap my mind around MM generally, and your post about how it relates to endogenous money creation more specifically. If what I said is not a correct understanding of MM, please let me know.

    1. Mark, you mostly got it right. Here is where I differ. First, the real developments like TFP ultimately drive real (i.e. inflation-adjusted) level of bank lending in the long run. That is why in the figure I above I have the 'structural' part in the 'expected future economy' box. The Fed can influence real lending in the short-run, the cyclical dimension. Second, if the Fed credibly targeted NGDP then animal spirits (at the business cycle frequency) would stabilize.

  9. I admit to not understanding market monetarism (I promise to read up), and being totally confused by the diagram. (Maybe everybody was.... not as much as myself.)
    The actual diagram that comes to mind when I hear market monetarism is the one you come to when you are driving on the stem portion of a “T” intersection.
    You cannot proceed without changing direction. You are free to go left (monetarism) or right (market). (Yeah, I’ve heard of the Reagan-Thatcher right-turn monetarism, which was just a change of focus from the cost of money to the quantity of money as a target of policy initiative.)

    To me, when ‘monetarism’ rises to a real modern macro-economic policy tool, it will not be about controlling interest rates to control the debt-based money quantity, it will be about controlling the money quantity. Directly. By governmental initiative.

    The recent work of Lord Adair Turner, former UK Chief of the Financial Services Authority, is akin to real, and necessarily radical, monetarism as a public policy initiative, and Turner proposes a specific mechanism that he calls “Permanent Overt Money Finance” (POMF) as the replacement for debt-contracts to advance M-1 money aggregates.

    The government exogenously creates the money supply through its budgeting process by financing its deficits, or portions thereof as required by good management, with a direct issuance of fiat-money based payments for goods and services procured within the budget..... issuing money and not debt-contracts..

    In the version of ‘monetarism’ discussed here, resort is made to traditional capital-“market” mechanisms that ostensibly influence further rounds of debt-contracting to solve our national, and global, debt-saturated economic paralysis. Good luck with that. Thanks.