Exogenous Money Research Paper

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Money is considered exogenous or endogenous depending on its relationship to the economy. If its existence and quantity are determined by the economy alone, money is considered endogenous. Conversely, if the existence and quantity of money are determined by forces outside the economy—most often by the state—money is considered exogenous. Since the inception of recorded monetary thinking, there has been an ongoing debate about whether money should be treated as endogenous or exogenous.

Much of this debate centers around the issues of (1) whether a royal or state authority should have the right to interfere in the monetary mechanism, and (2) whether the economy is better off with a growing money stock. For much of the medieval, Renaissance, and early modern periods, many writers argued that rulers should not be allowed to exercise their power over the monetary mechanism. This position was influenced by writers like Nicholas Oresme (c. 1320–1382), a French clergyman, mathematician, and economist, who argued that money belongs to the community and debasement was a violation of the people’s rights, and the English merchant and financier Thomas Gresham (c. 1519–1579), who famously proclaimed that debased coins will drive out full-bodied coins—or more generally that bad money drives out good money.

During the sixteenth and seventeenth centuries, a general consensus emerged that the quantity of money was a significant factor in determining the amount of domestic commerce. This conjecture was based on the observation that the gold and silver inflow from the Americas coincided with the general economic prosperity of the sixteenth century, while the economic depression of the seventeenth century commenced around the same time that the flow of precious metals across the Atlantic began to abate. The formulation of the quantity theory of money as a conceptual framework, often credited to the French political philosopher Jean Bodin (c. 1529–1596), further clarified the relationship between the money stock, prices, and economic activity. As a result, many theorists proclaimed that the key to national economic prosperity was to find a way to expand the money supply.

Hence, while many writers opposed royal manipulations of the money stock, in particular debasements, this position was problematized by the conviction that an increase in the money supply would generate economic prosperity. The question that was passed on to the next generation of monetary thinkers was whether the money supply should be increased from the inside or from the outside.

Before turning to the eighteenth-century view on this question, the perspective of these theorists on the broader relationship between money and the polity must be considered. One of the key debates among early modern thinkers concerned the role that money played in the formation of modern society. For the English philosopher John Locke (1632–1704), money served as an external force that sparked the transition from a state of nature to modern society, while for the Scottish philosopher and historian David Hume (1711–1776), money developed in conjunction with private property and markets. Hence, for some writers, money had an independent outside existence with the potential to transform the rest of society, while for others, money could only exist as an institution embedded inside society’s social and economic configuration.

John Locke also engaged in two long-lasting arguments regarding the relationship between the state and money. One of these debates centered around whether money had to be composed of a commodity with intrinsic value or whether it was possible for the government to use its authority to create money through fiat. Locke suggested that it was indeed semiotically necessary for money to be composed of a precious metal because people would only trust a currency that was grounded in something outside the authority of the state. By anchoring money to something incorruptible, like silver, people could trust money without having to rely on the state to behave responsibly. Others, such as Locke’s contemporary Nicholas Barbon (c. 1640–1698), argued the contrary position that the state can turn any object into money by its stamp of authority, as long as it is fully committed to keeping the money stock sufficiently scarce. Hence, for some writers, money functions best when it operates independently of the state, while for others, the state is responsible for the very existence of money.

The other debate that Locke was actively engaged in concerned whether the quantity of money should be determined by the economy or by the state—endogenously or exogenously. Locke opined, in agreement with some of his seventeenth-century mercantilist predecessors, that the quantity of money circulating in a nation should be dictated by the bullion flows between countries. That is, the only way to expand the nation’s money supply was to engineer a favorable balance of trade, either by producing tradable goods more efficiently or by imposing trade restrictions. Under such circumstances, the state had limited independent power over the quantity of money.

Others, such as the Scottish banker and monetary theorist John Law (1671–1729), proposed the establishment of a credit currency that could expand and contract in response to the amount of economic activity. Law proposed a credit currency backed by a tangible commodity, such as land, and administered by a bank that would only issue credit money to borrowers intending to use the money for legitimate investment projects. Law argued that a credit currency of this kind would allow the market to determine the proper amount of money—when the economy was prospering and the demand for money was high, the bank would be able to expand the money supply and thus facilitate the growth of the economy. As such, the quantity of money would be determined inside, or endogenously to, the economy.

The reality of the early eighteenth-century credit currencies, however, differed from Law’s proposal. Over time, the issuance of credit money by state-chartered banks, such as the Bank of England and the Bank Générale, was determined more by the interest of the state than by the demands of the economy. Hence, the emergence of a credit currency increasingly allowed the state to control the quantity of money in the economy. However, since the note-issuing bank was forced to redeem its paper notes with silver or gold on demand, states did not yet have complete control over the amount of money issued. Toward the end of the eighteenth century, however, when the state-chartered banks started issuing fiat money— paper money that was no longer redeemable for gold or silver—the state acquired a more direct method to control the money supply. A fully exogenous form of money had now developed.

David Hume provided one of the eighteenth-century’s most complete reflections on the difference between inside and outside, or endogenous and exogenous, money. He argued that money should always be organized and theorized as endogenous to the economy. Firstly, the origins of money occurred as part of an organic development of the economy, fully independent of the state. Secondly, the quantity of metallic money should always be determined by the specie-flow mechanism between countries, and the amount of credit money should be determined by the liquidity needs of the merchants and not the fiscal advantage of the state. Phrased within the quantity theory of money, Hume believed that the quantity of money was determined by the nation’s price level and its level of output—when output was increasing the price level would fall, encouraging exports and an inflow of specie to the country. Any attempt by the state to try to expand the money supply and thus treat money as if it were exogenous would only lead to inflation and possibly even a destabilization of the economy.

Hume did not have the final word on the issue of endogeneity and exogeneity. The conversation continued throughout the nineteenth century between bullionists and antibullionists, the currency school and the banking school. Once Keynesian ideas on countercyclical monetary policy were implemented systematically after World War II (1939–1945) and the state consistently treated the money supply as exogenous, the debate over the actual and proper relationship between money and the economy resurfaced, continuing to this day. These debates have centered around the extent to which the money stock is determined by the price level, interest rate, and output level (endogeneity) or whether the causality runs in the opposite direction with the money stock controlling prices, interest rates, and output (exogeneity). Part of this controversy is sustained by an inability to agree on a definition of money: whether the money stock is primarily composed of money with intrinsic value, credit money, or fiat money.

This issue has become even more complicated in the post–Bretton Woods era, when the U.S. dollar ceased to be redeemable for gold at a fixed price. This period has also witnessed rapid financial developments that have further blurred the definition of money. Add to this the tendencies toward transnational currencies, most prominently exemplified by the European euro, and the adoption of other nation’s currencies, such as the dollarization of Ecuador, and the issue of exogeneity and endogeneity becomes all the more complex. For example, the notion that the state is able to control exogenous money no longer holds. Nations that eliminate their own national currency in favor of the U.S. dollar clearly have an exogenously determined money stock, but one over which their own state cannot exercise any control.

In an economic world comprising many different forms of money and near-money, what dictates whether money is exogenous or endogenous is the level of abstraction of the inquiry. If the time horizon is long and the global economy is considered the unit of analysis, most forms of money appear to be endogenous. But if the time span is reduced and the focus is on a particular region, certain forms of money will be found to operate either with weak exogeneity or strong exogeneity. Hence, it is not just institutional features that determine whether money functions endogenously or exogenously; as important is the theoretical framework from which money is viewed.


  1. Desai, M 1992. Endogenous and Exogenous Money. In The New Palgrave Dictionary of Money, eds. John Eatwell, Murray Milgate, and Peter Newman, 146–150. London: Macmillan.
  2. Wennerlind, 2005. David Hume’s Monetary Theory Revisited: Was He Really a Quantity Theorist and an Inflationist? Journal of Political Economy 113 (1): 223–237.

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