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Financial Economics. Money Supply Process

The money supply process has a significant role in macroeconomic theory and policy. The debate over the determination of the money supply process exogenously or endogenously is often a disputed one. The monetary base and the general monetary aggregates (bank deposits) are correlated. This correlation is made effective through the money multiplier, whereas the determination of the money base and the factors influencing the size of the multiplier are the main dilemmas.

According to the mechanical approach, the money stock determination overlooks the complication of the money supply process. The monetary authorities presume that there is a suitable demand for money and the government in charge has direct control over the fiscal base of the system. In such situations, the money stock is exogenously determined by the authorities. On the other side, when there is a change in the monetary base to that of the aggregate demand, and the bank deposit multiplier is uneven then money supply is regarded as endogenous (Bandyopadhyay, T& Ghatak, S. 1990).

Exogenous money is that source of currency generated outside the nation and that comes to the nation for meeting the requirements of the society. On the other hand, endogenous money is the money generated within the nation, though issued by the central bank, and can be managed by the banking systems. It ensures effectiveness with socio-economic integrity (Exogenous and Endogenous Money). Traditionally, the money supply was regarded as exogenous due to the existence of factors contributing to the exogenous nature though past studies and practical evidence determine money supply is endogenous. Even the Post Keynesian theories reveal the role of money supply towards its endogenous nature. The growth of the money supply in the post-Keynesian framework is frequently viewed as endogenous. This endogeneity of money supply overturns the neoclassical belief that the supply of money is determined through the Central bank plans that depend on the factors external to financial markets. On the other hand, it argues that the supply of money in terms of variations and credit accessibility is determined by factors within the financial market. Due to these factors, the monetary authority is unable to control the volume of money stock because the creation of money is ultimately dependent on the demand. The structure of the money supply curve according to its vertical and horizontal size is always been a factor of discussion. The vertical structure denotes that the money supply depends on the total reserves, and these reserves being the liability of the central bank, are exogenously determined by the central bank. While on the other hand when the curve is horizontal, central banks set the interest rates to create liquidity for the bank deposits. They consider the interest rate as exogenous, but the money supply is determined as endogenous. There are three theories of money supply endogeneity that share a common view that money supply is determined from the demand side within financial markets. They are basically Accommodationists’ view, Structuralists’ view, and Liquidity Preference view. Basil Moore, a dedicated supporter of the accommodationists’ view believes credit money to be endogenous, which is determined by creditable borrowers (Ahmad. N &Ahmed. F. 2006).

The facts supported to determine the money stock as endogenous are: Basil Moore is of the opinion that the federal reserve itself practices a money market strategy. The central bank perseveres that the money stock creation is an outcome of the effort among the households, business corporations, financial institutions, and the federal reserves. The argument that exists regarding the central banks view to decide changes in the money stock, but at the same time, they do have appropriate reasons to use a measure of money stock growth that would result in undesirable ranges of interest rate fluctuation that in turn will weaken the financial market. If there was control over the reverse growth, then the private institutions would suffer due to short-term fluctuation of interest rates. Moreover, it was not sure that the liquidity of financial assets could be secured by holding cash inventories by private agents, in the absence of the functions of lender of last resort. In addition, there was also a requirement for an elastic currency to counterbalance the financial crisis ensuing from the interest rate fluctuations. The second factor supporting the argument was based on bank reserves and bank deposits. Studies reveal that the money stock was exogenous with reserves before and after implementation of the reserve accounting. The third support was from the modern microtheoritic model of the banking concerns. It analyzes a bank as a two-input, two output firm; inputs being retail and wholesale deposits and outputs being loans and wholesale lending. The banks were observed as price determiners because the retail deposits and loans were controlled through the banking system. The fourth support towards the endogeneity was based on the level with which the modification in the base can be explained statistically with the adjustment in the economic variables, especially monetary wages. Moore considered wages as a most descriptive variable with extreme positive co-efficient (Adams journal).

In short, Basil Moore considers the Central bank to be the sole issuer of the currency which can also decide the supply price of money at its diplomacy. According to him, the interest rates were exogenously decided by the Central banks. The increased expenditure creates more demand for the money by the households, which in turn increases the demand for loans from banks. When more loans are granted, it creates deposits. Under that circumstance, the deposits are regarded as a means of payment which in turn reflects in the increased money supply. The Structuralists consider money supply activities as the relations between the monetary authorities’ policies and the asset and liability management activities of the banks. Finally the followers of liquidity preference view money as endogenous due to the comparative interest rates that resolve the decision to borrow with the decision to hold increased deposits (Ahmad. N & Ahmed. F. 2006).

Reference

Adams journal Q (provided by the customer). Ahmad. N &Ahmed. F. 2006. The Long-run and Short-run Endogeneity of Money Supply in Pakistan: An Empirical Investigation. (online). Web.

Bandyopadhyay, T& Ghatak, S. 1990. Current Issues in Monetary Economics. Lanham; Rowman & Littlefield.

Exogenous and Endogenous Money. 2008. Web.