Tuesday, November 20, 2012

Fighting for Endogenous Money on Two Fronts

Yesterday evening, Daniel Kuehn had the following to say in a post about Endogenous money:
I think the whole idea of endogenous money is vastly overrated and the idea of exogenous money is vastly underrated.
If you want to say central banks care about interest rates, I'm fine with that. If you want to say that interest rates impact aggregate demand and that influences the broader definitions of the money supply, I'm fine with that. But monetary policy is still done by buying and selling high powered money (as far as I know - I've never talked to someone at the OMO desk), and it's done that way because while causality could run both ways (think of the old use of the discount window or Bagehot's dictums as an example of interest rates "causing" money creation), that's not how it works. Of course there is some target interest rate in mind (and THAT is only what gets churned out of some target inflation rate) - but you buy and sell stuff at the OMO desk because it causes that target interest rate to come to fruition.
My initial response in the comments was that:
Endogenous money is typically about much more than the manner by which central banks perform OMOs. You are correct that central banks typically buy and sell high-powered("outside") money to target a federal funds rate. However, a theory of endogenous money would argue that does little to control the inflation rate or aggregate demand within the economy. Instead, private banks create "inside" money (deposits) through lending that adds to aggregate demand and can create inflation. After lending, banks ensure they meet reserve requirements and the Fed ensures the entire banking system has enough reserves to maintain its target interest rate.
From this perspective, a money multiplier with respect to OMOs does not exist. Further, money and money-like instruments can be perceived as non-neutral, even in the long run. In these ways and more, the distinction between the two theories is far greater than you appear to let on.
(Note: Through QE, the Fed has been buying Treasuries and Agency-MBS, which are not forms of high-powered money)
Since then we have been engaged in some good dialogue back and forth about the merits and actual theory of endogenous versus exogenous money.

Separately, Jonathan Finegold has “a few quibbles” with Edward Harrison’s post on Endogenous Money and Fully Reserved Banking”:
Second, Harrison writes that bank reserves are irrelevant, because credit demand is endogenously determined; this is true, but  generally since demand for credit is practically limitless, reserves provide banks with the capital to lend. I don’t find it convincing to interpret the causality from loan origination to reserve provision (that is, banks lend and then the central banks provides the necessary reserves).
To which I responded:
As for the second point, the central bank always provides enough reserves (either through OMOs or the discount window) for the entire banking system to meet its requirements. Banks can also borrow/lend reserves to each other through the inter-bank market. Since the discount window entails an excess fee for banks, it marks the known upper bound at which reserves can always be obtained. Under normal, pre-2008, circumstances the Fed would adjust the total number of reserves in the banking system through OMOs to ensure it met its target interest rate. Now that the banking system has substantial excess reserves, the Fed uses IOER policy to set the interest rate and adjusts the amount of reserves to increase liquidity, shorten asset maturities in the private sector and alter expectations.
The theory of endogenous money is a significant departure from exogenous money and mainstream, neoclassical views. This fact makes its acceptance and understanding by people well-versed in the traditional view all the more difficult. Hopefully others will join in the conversations and help turn the tide!

Suggested Readings:
Understanding The Modern Monetary System @ Monetary Realism
Endogenous Money: What it is and Why it Matters by Thomas Palley
Endogenous money - Wikipedia, the free encyclopedia

Related Posts:
Fullwiler - "The main shortcoming of the money multiplier paradigm"
A Stinging Critique of Monetarism
The Money Multiplier Fairy Tale


  1. FYI, while the CB does do OMOs, these are 100% defensive to accommodate banks' demand for reserve balances at the target rate. The "permanent" operations--those that are not reversed--are 100% for the purpose of offsetting the drain in reserve balances that occurs when banks purchase currency from the Fed to replenish vault cash. The "temporary" operations are repos intended to offset some change to the Fed's balance sheet affecting reserve balances that day, or some swing in the demand for reserve balances due to increased payment settlement needs, etc. So, again, the operations are totally defensive, not offensive, as Kuehn's comment suggests. And they must be that way unless the Fed sets the target rate equal to IOR, as it has since 2008--that's the only way the Fed can have direct control over the qty of reserve balances.

    Scott Fullwiler

    1. Scott,

      Thanks for the comment...your expertise is always appreciated. While Daniel's initial post listed here does leave open the argument that OMOs are totally defensive (which I agree), his later comments suggest otherwise.

      The main point of contention appears to have become Daniel's suggestion "that reserves cause new money to be created." I take this as a separate argument than the offensive vs defensive nature of OMOs, whereby reserves control the broad money supply through a money multiplier effect.

      I acknowledge that my understanding and explanation of the subject remains incomplete. With the helpful input and research of yourself and others I hope to remedy that over time.

    2. Scott -
      I'm not sure what to make of your "offensive" and "defensive" terminology. But I can't imagine how OMOs could be considered passive (or more commonly - "accomodative") relative to active. The interest rate is manipulated by conducting OMOs. OMOs don't just happen as a result of declarations about the interest rate. I can't think of how else to describe that except to say that the base money changes exogenously to achieve an interest rate target (larger monetary aggregates, of course, emerge endogenously according to demand for loans, etc.).

  2. Daniel,

    It's very well established that the FEd does NO OMOs to alter the fed funds target. It simply announces a new target. The OMOs are simply to accommodate changes in the demand for balances (daily swings) and offset changes to its own balance sheet that otherwise would not be consistent with the target rate. None of this is controversial in the literature on Fed operations. You might want to check it out.


  3. "Reserves cause new money to be created" is an odd phrase.

    If one means that OMOs add to reserves (actually, the correct term is reserve balances here, not reserves) and deposits of the primary dealer, then this is true to the extent that the dealer is not a bank (not always true). But if this means that more reserve balances enable banks to create more deposits--i.e., banks are constrained in expanding deposits by their reserve balances--then this is undeniably incorrect.

    It seems we are having a discussion from a textbook view here, and it needs to get up to speed with the actual research. Unfortunately, there are no textbooks that have done this yet.

    Scott Fullwiler

  4. Late to the party. Good post, Woj, & a great set of comments.

    I understand this bit the way DK does: "you buy and sell stuff at the OMO desk because it causes that target interest rate to come to fruition." I have argued that what the Fed "controls" is the quantity of base money (or reserves, or reserve balances, or something like that) and NOT interest rates. The FedFunds rate is the TARGET; the Fed manipulates ("controls") its issue to approach the target.

    I missed the connection between that view of DK and your thoughts on what endogenous money is about (the hobbyist said).

    I don't know how old STF is (hi, Scott), but it strikes me that perhaps he did not live thru the Chairman Volcker years. (RE: STF of 7:47 pm)
    The Fed can "announce a new target" at will, even a double-digit target -- and were it to do that, the "demand for balances" would probably change. To say "CB does do OMOs, these are 100% defensive to accommodate banks' demand for reserve balances at the target rate" (STF 12:17PM) is to suggest that the banks being accommodated are in control. But again, at the drop of a hat the Fed can change the target rate. I think the Fed's role is understated in the STF boilerplate.

    Oh, also (like DK) I find the words "defensive" and "offensive" inappropriate. Given a Price target, and given the Demand for funds, the Fed adjusts the Supply. Supply and Demand. No biggie.

    1. Better late than never :-)

      Perhaps surprisingly, I have to disagree with your first paragraph. In normal times (pre-IOR), the Fed could either control the interest rate or the monetary base, but not both. Typically the Fed elected to target the interest rate, adjusting the monetary base in response to the actions of Treasury and private banks. Perhaps that language is better than "defensive"?

      Now that the Fed is paying IOR (and IOER), it actually can control both the monetary base and the interest rate separately. This is why I doubt the Fed ever returns to the old way.

      The debate about endogenous money, in my mind, comes down to whether or not the money supply driving aggregate demand stems primarily from "outside" money (e.g. Fed, Treasury) or "inside" money (e.g. private banks). My claim is that the latter is far more important to aggregate demand. Recent history appears to support this view as the monetary base has tripled while NGDP remains rather subdued.

  5. I like your reference to "normal times". It is important to make the distinction.

    "Now that the Fed is paying IOR (and IOER), it actually can control both the monetary base and the interest rate separately."

    Good point. I'm thinking that as the "monopoly supplier" the Fed can set both the price and the quantity supplied...

    One works so hard to understand the world, and then the world changes. Those who understand the new cannot understand where the rest are coming from. And the reverse.

    Thanks Woj.

  6. I should add: if endogenous has become more significant than exogenous money, the reason is the quantitative dominance of endo -- as one may see in the debt-per-dollar graph. A result of unfettered financial innovation.