Endogenous or Exogenous Money
There are quite a few arguments in economics which are entirely superfluous. One of them is over whether central banks determine the money supply or whether it is determined by the banking sector. I have dealt with this previously (following along on the coat tails of Rowe and Sumner) but as I work through Keen’s lectures on “endogenous money” (see primarily 06 part 2 and 07 part 1) I can’t help but notice that this issue seems to be central to much of his criticisms of mainstream economics. So in pursuit of my ultimate goal of rescuing the theory of money and debt from the Marxists–er, I mean “post Keynesians”–and folding it somehow neatly into regular old-fashioned economics, let me first address this whole endogenous/exogenous ball of wax.
The first problem with this debate is that it usually begins with a misunderstanding of the significance of those terms. Endogenous and exogenous only have meaning in the context of a model. A model can be designed in such a way that it treats something as exogenous, meaning that the determination of it is not explained in the model but taken for granted, or it can be designed in such a way that that thing is endogenous or determined in the model. Neither one of these is right or wrong. In the real world, everything is endogenous (except the laws of nature and some set of initial conditions). Of course, if we are trying to demonstrate how or why a thing is what it is, we have to make a model in which it is endogenous or we are just saying what it is without adding any additional layers of logic to justify it.
Now keen characterizes the debate as over money being exogenous to “the economy.” However, I think most staunch “exogenous money” types would still agree that the behavior of the central bank depends to some extent on conditions in the economy. So, in some sense, as I said, everything is endogenous. But let’s be honest, that is dancing around the issue. The real question is what is the best way to model monetary policy. It is hard to make a model where everything is endogenous. And monetary policy, at least in theory, could be conducted independently of other conditions in the economy. And furthermore, a large part of what we are usually trying to determine/demonstrate is the effect of monetary policy. So it makes sense to treat this, somehow defined, as exogenous. The question then becomes how to define it.
At this point, we arrive at the real crux of the matter. The exogies claim that the central bank determines the quantity of base money and then the market determines the rate of interest. The endogeroos insist that it is the other way around and the central bank merely determines the rate of interest and then the economy determines how much base money is needed and the central bank supplies it. Now we have a report from the bank of England which tells us that what banks really do is the latter. But the problem with Keen’s exposition on the subject is that he seems to act as though the rate of interest set by the central bank has no effect on the quantity of money which is thusly “endogenously” determined.
Essentially, this boils down to a common “paradox” in principles classes. Does the monopolist take price for granted and choose a quantity or take quantity for granted and choose a price? Answer: No. The monopolist takes the demand curve for granted and chooses a price/quantity pair along that demand curve. And so it is with the monetary authority, at least in the short run. In the long run, there is a sort of supply and demand for money, though it is difficult to characterize them precisely. The supply takes the form of some kind of reaction function by the central bank specifying either the quantity of money they will provide (if you are an exogie) or the short-term interest rate they will charge (if you are an endogeroo) under all possible economic scenarios. The demand can be thought of as the quantity of money “the economy” will “demand” at any given interest rate (if you are an endogeroo) or the short-term interest rate that they will bid up to for any given quantity of money (if you are an exogie) under any given set of economic circumstances. These two then interact in a very complicated way to determine the interest rate and the quantity at any given moment and market expectations of them at all points in the future which are represented by prices (including various interest rates).
Now, is the quantity or the price (interest rate) endogenous? Answer: yes. Better answer: they both are, of course, that’s supply and demand 101, can we get some harder questions in here?
So for most practical purposes, this distinction doesn’t matter. It becomes the horizontal/vertical supply curve debate which Keen alluded to but I didn’t see him address (maybe he did it earlier). That might make a difference for some minor reasons like the effect of misestimating demand or of changes in demand in the ultra-short run (faster than the CB can adjust policy) but as far as the big picture is concerned, this is a smokescreen.
But Keen seems to take it a step further than just arguing about what I would consider a bit of meaningless minutia. He seems to be implying that monetary policy in general is not exogenous. Which, in this context, since we know that the CB has the ability to determine monetary policy independently of what is happening in the economy, amounts to the statement: monetary policy is meaningless. Here is the argument “in a nutshell.” For the record, Keen is quoting Basil Moore. By the end, the astute observer, thoroughly trained in sound “neoclassical” economics should see the flaw in this reasoning leaping off the page (or screen, as the case may be).
“Changes in wage and employment largely determine the demand for bank loans which, in turn determine the rate of growth of the money stock.
Central banks have no alternative but to accept this course of events, their only option being to vary the short-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 borrowers demand.” (Moore 1:3-4)
In a nutshell
-The supply of money and credit is determined by the demand for money and credit. There is no independent supply curve as in standard micro theory.
-All the state can do is affect the price of credit (the interest rate).
Did you spot it? Here’s a hint: a monopolist doesn’t have a supply curve. Does that mean the monopolist’s quantity is determined only by the demand curve? No, because the monopolist can control the price. But wait! says the smart kid in the front of the class. If he doesn’t have a supply curve, and he is facing a given demand, and he controls the price, then isn’t he effectively choosing a quantity? Like, couldn’t we just as easily say that he controls the quantity and the price is determined by the demand curve given that quantity?
Yes! Bonus points for the smart kid who doesn’t need them anyway! Now all of the other people in the class hate your guts even more, congratulations! A demand curve can’t determine a quantity all by itself. There has to be something else determining which point along the demand curve we are at. You can say that the central bank sets the price and then the demand curve, along with that price determine the quantity. If you say that the CB sets the quantity and the demand curve, along with that quantity, determines the price, it’s not really different (assuming the demand curve is fixed and the CB knows what it is. No doubt, Keen would say “well those assumptions aren’t true so your whole theory is garbage” but those are at best second order concerns).
Keen’s (and I guess Moore’s) mistake is to ignore the effect of controlling the price of money (interest rate) on the quantity demanded. He acts as if this is a meaningless novelty. But if the demand curve is downward sloping, this is everything.
Furthermore, the Keen/Moore theory has a gaping hole in the middle of it. He claims that the money supply doesn’t “cause” price increases but that price increases cause an increase in the money supply. But that leaves us with no way of determining a price level (or a change therein). By the way, this is why it’s hard to make a model where everything is endogenous. What determines all of them in that case? Each exogenous variable you want to make endogenous requires another equation to identify it. This presents problems if you are trying to have all of your equations make sense for some reason. On the other hand, if you are just assigning arbitrary relationships between variables and calibrating them to fit the data, then no problem.
Finally, Keen begins with an empirical analysis by Kydland and Prescott which apparently finds evidence that changes in the money base lag the business cycle while changes in credit money (M1-M0) lead the cycle. This is not surprising to me and fits with my view of the role of credit and monetary policy in the business cycle (which, for the record, I think has a lot of overlap with Keen’s view) but this does not prove that one causes the other. The flaw is in Keen’s notion that if X follows Y, X couldn’t have caused Y (and therefore by implication, Y must have caused X). Though he does make some equivocations for this, I think it shows what happens when you try to strip the “agent” out of economics, which seems to be Keen’s overarching mission. You treat relationships between variables like the sterile cause/effect relationships that underlie most of the hard sciences. The rate of acceleration due to gravity (near the earth’s surface) just is what it is and it is just a matter of measuring it.
In economics, things are seldom that straightforward. Because you are modeling the behavior of thinking people, they have the ability to anticipate things that will happen in the future and this affects their actions today and in turn affects what happens in the future, just like those movies in the eighties with Michael J. Fox, it becomes a whole confusing mess with paradox on top of paradox that is difficult to sort out. Or, to put it in the words of Scott Sumner quoting Paul Krugman: “it’s a simultaneous system.”