Endogenous Money

Updated on April 8, 2024
Article byAswathi Jayachandran
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Endogenous Money?

Endogenous Money is an economic concept that states that there is a causal link between the economy’s money supply and the lending of banks. According to the post-Keynesian tradition, bank lending affects the money supply, and the imbalance between money supply and demand governs the business cycle.

Endogenous Money Theory

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It is important to understand the endogenous concept of money since it emphasizes the relationship between credit creation, money lending, and economic activity, as well as acknowledging the function of banks in the production of money. The concept aids in understanding the components of the macroeconomy, the monetary policies framed, and the financial stability of nations.

Key Takeaways

  • The endogenous money concept states that an economy’s money supply is determined internally rather than by a central bank or other outside body. It claims that it is instead caused by how numerous economic factors interact.
  • Endogenous theory highlights banks’ role in money and credit creation, affecting monetary policy and financial stability.
  • Central banks have limited influence on money supply, and changes impact investment, growth, and aggregate demand.
  • Understanding the endogenous concept of money is crucial as it highlights the connection between credit creation, money lending, and economic activity, and the role of banks in money production.

Endogenous Money Explained

Endogenous money refers to the idea that a central bank or other external authority does not set an economy’s money supply. It states that the interactions of many economic variables rather decide them. The endogenous concept goes against the traditional idea of money. According to the traditional money multiplier theory, the central bank prints money, puts it in banks, and then lends part of it out. After being lent again, this money is placed in banks and is used for further loans. The money multiplier is a concept that reveals how much more money is in the economy overall as a result of the initial financial infusion.

According to the opposing viewpoint, banks are not dependent on depositors or the central bank for funding to make loans. Rather, they create money—also known as keystroke money—by simply putting the loan amount in their ledgers. As the bank must return the loan to the consumer should they decide to use it, the loan is both an asset that belongs to the customer and a liability.

In the money multiplier concept, the central bank injects initial base money, which progressively seeps through the banking system and increases the amount of money available in broader metrics, including the M1. When money is endogenous, banks lend money first and expand the money supply in broader measures. Central banks then provide base money and grow after that.

History

The concept of exogeneity and endogeneity pertains to the origin and evolution of money. While some argue that authorities introduce money, making it an exogenous creation of law and the state, others, following Menger’s theory, propose a spontaneous or organic genesis of money as the mainstream view. Menger argued that individuals engage in economic exchange, gradually selecting a common medium of exchange, money, based on its marketability and ability to reduce transaction costs.

The second aspect of exogeneity and endogeneity relates to the transition from commodity money to fiat money. Mainstream economists believe that this evolution occurred endogenously as individuals economized on production and transaction costs. Austrian economists, however, contend that fiat money resulted from exogenous government intervention in the monetary sphere rather than emerging naturally in the free market.

Some argue that the stock of money in a nation depends on the demand for bank credit, which, in turn, depends on economic variables influencing output levels. Some argue that the supply of money expands and contracts in response to production needs and expectations of aggregate demand through the banking system. One can, however, say that the debate surrounding exogeneity and endogeneity primarily revolves around determining the quantity of money.

Examples

Let us look into a few examples to understand the concept better.

Example #1

Let us assume the ABC Bank operates in a country where the determination of money supply takes place endogenously. When ABC Bank extends loans to borrowers, it creates new money by crediting the borrowers’ accounts. This promotes economic activity and expands the money supply in the economy. 

The lending choices made by ABC Bank, which are impacted by variables like interest rates and credit demand, have a big impact on the nation’s overall money supply and economic dynamics.

Example #2

This paper on “An Endogenous Money Perspective On The Post-Crisis Monetary Policy Debate” by Scott T. Fullwiler serves as an argument in favor of why money is endogenous.

The integration of the endogenous concept of money and central bank operations is examined in the research, along with how they relate to ongoing policy discussions about monetary theory and practice. It offers a thorough explanation of how banks operate. It helps in understanding how central banks operate, including how they create and grant credit, as well as how dealer markets set prices, supply funding, and maintain market liquidity.

The research finds that understanding banking is challenging due to the prevailing views that external control over a monetary aggregate influences macroeconomics and the prevalence of the money multiplier mode. It conceals the actual character of central bank activities in both regular and irregular circumstances.

Importance

Here are few reasons that make endogenous money important:

1. Lending and credit creation

The emphasis of endogenous theory is on banks’ contribution to money creation through lending activities. It is essential to comprehend the dynamics of credit creation and the effects of bank lending on the economy.

2. Impact on the monetary policy

Endogenous money theory suggests that central banks may only have a limited amount of influence over the money supply, which has implications for monetary policy. It also suggests that managing the economy may require more than just interest rate policy. When creating monetary policy, banks must take the nation’s money supply, lending, and credit creation into account.

3. Financial stability

It emphasizes how crucial the role of the banking industry is in maintaining financial stability. This is because crises and instability in the economy can result from unsustainable lending practices. It aids in determining the risks involved in the system.

4. Macroeconomic aspects

The idea sheds light on the connection between credit, money, and economic activity. This is so because adjustments to bank lending practices and the money supply may have an impact on investment, economic growth, and aggregate demand.

Endogenous Money vs Exogenous Money

The differences between both the concepts are as follows:

PointsEndogenous MoneyExogenous Money 
ConceptIt states that the demand for loans and the lending activities of commercial banks determine the amount of money in circulation.    Exogenous money refers to a money supply that is managed and set by a central bank.  
Control of central banks  Central banks do not have exclusive control over the money supply.    Exogenous money asserts that central banks have exclusive control over the money supply.
Essence  The idea states that money supply and demand are correlated.    Exogeneity is the state in which the money supply is unaffected by market demand.

Frequently Asked Questions (FAQs)

1. What is endogenous money supply?

The term endogenous money supply describes the theory that the demand for loans and bank lending operations control the amount of money available in the economy. In contrast, the exogenous money supply hypothesis suggests that the central bank controls and determines the money supply through monetary policy implementation.

2. What is a defining feature of endogenous money theory?

Endogenous money theory emphasizes the role of commercial banks in money formation, arguing that banks increase the economy’s money supply. They create new money while providing loans, challenging the conventional money multiplier theory where the central bank controls the money supply.

3. Is LM PC with endogenous money?

It examines the dynamics of output and inflation using the Investment Savings (IS), Money Supply (LM), and Phillips Curve (PC) models. It considers the central bank’s policy decision to modify the real interest rate and inflation in the economy. Interest rates are considered an endogenous variable.

This article has been a guide to what is Endogenous Money. Here, we compare it with exogenous money, and explain its examples, history, and importance. You may also find some useful articles here –

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