Endogenous Money Research Paper

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Economists have disputed the nature of money since the dawn of capitalism. Two polar positions have evolved: the quantity theory (also known as monetarism) and endogenous money. The former emphasizes money’s role as a means of exchange, and argues that the money supply is primarily controlled by the government. The latter emphasizes money as a unit of account, and argues that the supply of money is determined primarily by the credit operations of commercial banks. Each theory acknowledges that the total money supply is the sum of fiat money produced by the government and credit money produced by commercial banks, but the theories differ in their views of the hypothesized causal sequence.

The well-known quantity theory sees causation as running from fiat to credit money. The government determines the volume of base money (M0) by printing currency and borrowing from the central bank. This is deposited with commercial banks, which then create credit money (M2 minus M0) via fractional banking, where they retain a fraction m (the money multiplier) of the deposits, and lend the remainder. The redepositing of this loaned fraction by borrowers amplifies the initial creation of fiat money, so that the total money supply (M2) ultimately equals m times M0. Deposits are thus needed to create loans, and credit money is created from fiat money via a time-lagged process. The quantity theory puts primary responsibility for the rate of inflation on the government, since it can manipulate the quantity of money via changes to M0 and m. The ratio between the money supply and the volume of output in turn determines the price level.

In contrast, endogenous money asserts that credit money is created by commercial banks in response to the needs of predominantly large companies for working capital and investment finance. To ensure an adequate supply of working capital, large companies arrange lines of credit with banks that function rather like individual credit lized is determined by the borrower, not the bank. Investment finance is only forthcoming if banks agree to issue loans, which enables them to ration credit to borrowers with poor credit ratings. However, banks compete to provide investment finance to highly rated corporations, so that in general the demand for money by corporations determines the supply of credit money by banks.

When a corporation utilizes its line of credit to pay a supplier, the firm’s recorded debt to the bank increases, and simultaneously the supplier’s account is credited with newly created credit money. When the corporation negotiates an investment finance loan, its debt to the bank increases and simultaneously an identical sum of credit money is deposited in its account with the bank. In either case, the bank loan instantly creates an identical deposit— the reverse of the causal relation between loans and deposits of the quantity theory, with no time lag.

Instead, there is a lag between the creation of new credit money by the commercial banks and the generation of new fiat money by the government. According to endogenous money theorist Basil Moore, the government’s primary role is to ensure that the financial system does not experience crises like those that periodically racked the largely credit money system of nineteenth-century America—culminating in the Great Depression. It does this by providing sufficient currency to meet the public’s need for “cash in hand,” and by modifying the regulatory requirements on any bank that experiences a run to ensure that depositors’ demands for cash can be met.

Endogenous money theory thus sees the government as largely captive to the needs of the corporate and finance sectors, and only able to influence the rate of credit creation at the expense of serious disruptions to economic activity by causing liquidity crises. The one aspect of the financial system that the government does control is the interbank interest rate, which then sets the floor for shortterm commercial interest rates.

The quantity theory still dominates economics pedagogy in the form of the exogenous money supply of the IS-LM model, and economic theory in the form of rational expectations macroeconomics. However, the world’s central banks subscribe to endogenous money theory, implicitly if not explicitly, in that they abandoned any attempt to control the supply of money after the monetarist-inspired experiments by the U.S. and British governments in the 1980s. While inflation was gradually reduced, economic activity was severely disrupted, and the central banks consistently failed to meet their money creation targets—normally by large margins.

These failed practical experiments were reinforced by empirical research in the 1990s, which found that changes in M2 – M0 preceded changes in M0 by up to a year—a result that is consistent with endogenous money and contradicts the quantity theory. Though empirically confirmed, the theory of endogenous money is less well developed than its quantity/monetarist rival, and is still undergoing development.

Augusto Graziani’s proposition that all exchanges in a monetary economy involve a single commodity and three parties—a seller, a buyer, and a bank that records payment as a transfer from the buyer’s account to the seller’s—clarified John Maynard Keynes’s (1883–1946) argument that a monetary economy is fundamentally different from a barter economy, and therefore that the neoclassical model of a barter economy cannot adequately describe its behavior. However Graziani’s attempt to analyze monetary circulation confused the issue of how monetary profits are generated from borrowed money. Endogenous money theorists also have yet to resolve how much influence banks have vis-à-vis firms in determining the money supply, with the subhypothesis that banks are completely passive being labeled horizontalism or accommodationism, while the alternative that banks have some control over the quantity and terms of money supply is known as structuralism. Other contributors to the debate argue that current disputes in endogenous money emanate from a confusion of stocks with flows, an argument made by Keynes in 1937 when outlining a distinctly endogenous view of money creation, in contrast to the predominantly exogenous perspective that dominated his General Theory of Employment, Interest, and Money (1936).


  1. Dow, Sheila, Endogenous Money. In A “Second Edition” of the General Theory, eds. Geoffrey C. Harcourt and P. A. Riach, Vol. 2, 61–78. London: Routledge.
  2. Graziani, Augusto. The Monetary Theory of Production. Cambridge, U.K.: Cambridge University Press.
  3. Keen, Stev 2006. The Need and Some Methods for Dynamic Modelling in Post Keynesian Economics. In Complexity, Endogenous Money, and Macroeconomic Theory: Essays in Honour of Basil J. Moore, ed. Mark Setterfield, 36–59. Aldershot, U.K.: Edward Elgar.
  4. Keynes, John Maynard Alternative Theories of the Rate of Interest. Economic Journal 47: 241–252.
  5. Kydland, Finn , and Edward C. Prescott. 1990. Business Cycles: Real Facts and a Monetary Myth. Federal Reserve Bank of Minneapolis Quarterly Review 14 (2): 1–17.
  6. Moore, B 1983. Unpacking the Post-Keynesian Black Box: Bank Lending and the Money Supply. Journal of Post Keynesian Economics 5: 537–556.

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