Endogenous money

Endogenous money constitutes the cornerstone of post-Keynesian monetary theory, which underlines that the supply of money is determined by the demand for means of payment. An effective presentation of this theory has been proposed by Moore (1988), who differentiates between horizontalists and verticalists. The mainstream theory reflects the verticalist view and states that the money supply function is exogenous, independ- ent from money demand and controlled by the central bank. By contrast, according to endogenous money theory, which reflects the horizontalist view, the supply of money is demand determined, and the central bank can only control the rate of interest, not the quantity of money.

The origin of the modern version of endogenous money theory can be traced back to Joan Robinson (1956) and Nicholas Kaldor (1970). Kaldor intended the endogenous money theory to be an instrument to resist the spread of Friedman's monetarist counter- revolution. Friedman set out to reaffirm the validity of the quantity theory of money and identified an empirical criterion, namely the analysis of the relation between quantity of money and nominal income, in order to falsify Keynesian or monetarist theories. The presence of a direct relation between these two variables would have been consistent with the quantity theory of money and would have falsified Keynesian theories. The empirical evidence gathered by Friedman showed the existence, for a period of over 100 years in the United States and United Kingdom, of a strong relation between the quantity of money and nominal income. Kaldor replied to Friedman that in a world in which credit money is used, the causal relation between quantity of money and income goes in the opposite direction to that maintained by monetarists (see Bertocco, 2001, 2010).

There are different approaches to endogenous money that can be described by using two different classification criteria. One distinguishes between the evolutionary and the revolutionary views (see Rochon and Rossi, 2013). The evolutionary view states that endogenous money theory is characterized by the explicit consideration of the evolu- tion of banking. Chick (1986) specifies different stages in the evolution of banking: in the early stages banks are no more than intermediaries that lend what they receive from savers. In the later stages when deposits become means of payment and the central bank has "fully accepted responsibility for the stability of the financial system" (Chick, 1986, p. 115), banks lend money that they themselves create. The revolutionary view states that money has always been endogenous irrespective of central bank behaviour and the stage of development of the banking sector, because "money has always been responding to the needs of markets for a means of final payment" (Rochon and Rossi, 2013, p. 216).

The second criterion makes a distinction between the horizontalist and the structur- alist approaches. The differences between these views concern two points, namely the slope of the credit supply curve and the relevance of liquidity preference theory. The horizontalist approach assumes that the credit supply curve is perfectly elastic with respect to the rate of interest set by banks, while the structuralist view maintains that because of the non-accommodating behaviour of either the monetary authority or banks, the supply of credit is an increasing function of the interest rate. With regard to the second point, structuralists accuse horizontalists of having neglected liquidity pref- erence theory (see Dow, 1997). It can be shown (see Bertocco, 2010) that if two distinct markets are specified - the interbank market and the credit market - the presence of a perfectly elastic bank-credit supply curve does not imply the abandonment of liquidity preference theory.

Since the beginning of the 1990s, a particular version of endogenous money theory was accepted by mainstream economists and by central bankers who abandoned the control of monetary aggregates and instead targeted short-term interest rates. This version derives from Wicksell's analysis of a pure credit economy. Wicksell (1898 [1969], p. 76) observes that in a pure credit economy in which only bank money is used, "[h]owever much 'money' is demanded in the banks, they can pay it out [. . .] since they do nothing about it, but enter a few figures in their books [. . .]. Supply and demand of money have in short now become one and the same thing." This approach assumes that a natural rate of interest exists, and reiterates the pre-Keynesian principle of money neutrality (see Smithin, 2013). In contrast to this view, the endogenous money theory characterizing the post-Keynesian approach is a basic element to elaborate a "monetary theory of produc- tion" that explains the non-neutrality of money. Indeed, this theory allows us to explain:

(i) the principle of effective demand and the causal relationship between investment and saving decisions; (ii) the relationship between saving and wealth; and (iii) the monetary nature of uncertainty (see Bertocco, 2013a, 2013b).

See also:

Bank deposits; Banking and Currency Schools; Bank money; Interdependence of money demand and supply; Monetarism; Monetary circuit; Monetary theory of distribution; Money and credit; Money creation; Money creation and economic growth; Money neutrality; Money supply; Natural rate of interest; Quantity theory of money; Wicksell, Knut.