Home > Macro/Monetary Theory > Endogenous or Exogenous Money

Endogenous or Exogenous Money

There are quite a few arguments in economics which are entirely superfluous.  One of them is over whether central banks determine the money supply or whether it is determined by the banking sector.  I have dealt with this previously (following along on the coat tails of Rowe and Sumner) but as I work through Keen’s lectures on “endogenous money” (see primarily 06 part 2 and 07 part 1) I can’t help but notice that this issue seems to be central to much of his criticisms of mainstream economics.  So in pursuit of my ultimate goal of rescuing the theory of money and debt from the Marxists–er, I mean “post Keynesians”–and folding it somehow neatly into regular old-fashioned economics, let me first address this whole endogenous/exogenous ball of wax.

The first problem with this debate is that it usually begins with a misunderstanding of the significance of those terms.  Endogenous and exogenous only have meaning in the context of a model.  A model can be designed in such a way that it treats something as exogenous, meaning that the determination of it is not explained in the model but taken for granted, or it can be designed in such a way that that thing is endogenous or determined in the model.  Neither one of these is right or wrong.  In the real world, everything is endogenous (except the laws of nature and some set of initial conditions).  Of course, if we are trying to demonstrate how or why a thing is what it is, we have to make a model in which it is endogenous or we are just saying what it is without adding any additional layers of logic to justify it.

Now keen characterizes the debate as over money being exogenous to “the economy.”  However, I think most staunch “exogenous money” types would still agree that the behavior of the central bank depends to some extent on conditions in the economy.  So, in some sense, as I said, everything is endogenous.  But let’s be honest, that is dancing around the issue.  The real question is what is the best way to model monetary policy.  It is hard to make a model where everything is endogenous.  And monetary policy, at least in theory, could be conducted independently of other conditions in the economy.  And furthermore, a large part of what we are usually trying to determine/demonstrate is the effect of monetary policy.  So it makes sense to treat this, somehow defined, as exogenous.  The question then becomes how to define it.

At this point, we arrive at the real crux of the matter.  The exogies claim that the central bank determines the quantity of base money and then the market determines the rate of interest.  The endogeroos insist that it is the other way around and the central bank merely determines the rate of interest and then the economy determines how much base money is needed and the central bank supplies it.  Now we have a report from the bank of England which tells us that what banks really do is the latter.  But the problem with Keen’s exposition on the subject is that he seems to act as though the rate of interest set by the central bank has no effect on the quantity of money which is thusly “endogenously” determined.

Essentially, this boils down to a common “paradox” in principles classes.  Does the monopolist take price for granted and choose a quantity or take quantity for granted and choose a price?  Answer: No.  The monopolist takes the demand curve for granted and chooses a price/quantity pair along that demand curve.  And so it is with the monetary authority, at least in the short run.  In the long run, there is a sort of supply and demand for money, though it is difficult to characterize them precisely.  The supply takes the form of some kind of reaction function by the central bank specifying either the quantity of money they will provide (if you are an exogie) or the short-term interest rate they will charge (if you are an endogeroo) under all possible economic scenarios.  The demand can be thought of as the quantity of money “the economy” will “demand” at any given interest rate (if you are an endogeroo) or the short-term interest rate that they will bid up to for any given quantity of money (if you are an exogie) under any given set of economic circumstances.  These two then interact in a very complicated way to determine the interest rate and the quantity at any given moment and market expectations of them at all points in the future which are represented by prices (including various interest rates).

Now, is the quantity or the price (interest rate) endogenous?  Answer: yes.  Better answer: they both are, of course, that’s supply and demand 101, can we get some harder questions in here?

So for most practical purposes, this distinction doesn’t matter.  It becomes the horizontal/vertical supply curve debate which Keen alluded to but I didn’t see him address (maybe he did it earlier).  That might make a difference for some minor reasons like the effect of misestimating demand or of changes in demand in the ultra-short run (faster than the CB can adjust policy) but as far as the big picture is concerned, this is a smokescreen.

But Keen seems to take it a step further than just arguing about what I would consider a bit of meaningless minutia.  He seems to be implying that monetary policy in general is not exogenous.  Which, in this context, since we know that the CB has the ability to determine monetary policy independently of what is happening in the economy, amounts to the statement: monetary policy is meaningless.  Here is the argument “in a nutshell.”  For the record, Keen is quoting Basil Moore.  By the end, the astute observer, thoroughly trained in sound “neoclassical” economics should see the flaw in this reasoning leaping off the page (or screen, as the case may be).

“Changes in wage and employment largely determine the demand for bank loans which, in turn determine the rate of growth of the money stock.

Central banks have no alternative but to accept this course of events, their only option being to vary the short-term rate of interest at which they supply liquidity to the banking system on demand.

Commercial banks are now in a position to supply whatever volume of credit to the economy that their borrowers demand.” (Moore 1:3-4)

In a nutshell

-The supply of money and credit is determined by the demand for money and credit.  There is no independent supply curve as in standard micro theory.

-All the state can do is affect the price of credit (the interest rate).

Did you spot it?  Here’s a hint: a monopolist doesn’t have a supply curve.  Does that mean the monopolist’s quantity is determined only by the demand curve?  No, because the monopolist can control the price.  But wait! says the smart kid in the front of the class.  If he doesn’t have a supply curve, and he is facing a given demand, and he controls the price, then isn’t he effectively choosing a quantity?  Like, couldn’t we just as easily say that he controls the quantity and the price is determined by the demand curve given that quantity?

Yes! Bonus points for the smart kid who doesn’t need them anyway!  Now all of the other people in the class hate your guts even more, congratulations!  A demand curve can’t determine a quantity all by itself.  There has to be something else determining which point along the demand curve we are at.  You can say that the central bank sets the price and then the demand curve, along with that price determine the quantity.  If you say that the CB sets the quantity and the demand curve, along with that quantity, determines the price, it’s not really different (assuming the demand curve is fixed and the CB knows what it is.  No doubt, Keen would say “well those assumptions aren’t true so your whole theory is garbage” but those are at best second order concerns).

Keen’s (and I guess Moore’s) mistake is to ignore the effect of controlling the price of money (interest rate) on the quantity demanded.  He acts as if this is a meaningless novelty.  But if the demand curve is downward sloping, this is everything.

Furthermore, the Keen/Moore theory has a gaping hole in the middle of it.  He claims that the money supply doesn’t “cause” price increases but that price increases cause an increase in the money supply.  But that leaves us with no way of determining a price level (or a change therein).  By the way, this is why it’s hard to make a model where everything is endogenous.  What determines all of them in that case?  Each exogenous variable you want to make endogenous requires another equation to identify it.  This presents problems if you are trying to have all of your equations make sense for some reason.  On the other hand, if you are just assigning arbitrary relationships between variables and calibrating them to fit the data, then no problem.

Finally, Keen begins with an empirical analysis by Kydland and Prescott which apparently finds evidence that changes in the money base lag the business cycle while changes in credit money (M1-M0) lead the cycle.  This is not surprising to me and fits with my view of the role of credit and monetary policy in the business cycle (which, for the record, I think has a lot of overlap with Keen’s view) but this does not prove that one causes the other.  The flaw is in Keen’s notion that if X follows Y, X couldn’t have caused Y (and therefore by implication, Y must have caused X).  Though he does make some equivocations for this, I think it shows what happens when you try to strip the “agent” out of economics, which seems to be Keen’s overarching mission.  You treat relationships between variables like the sterile cause/effect relationships that underlie most of the hard sciences.  The rate of acceleration due to gravity (near the earth’s surface) just is what it is and it is just a matter of measuring it.

In economics, things are seldom that straightforward.  Because you are modeling the behavior of thinking people, they have the ability to anticipate things that will happen in the future and this affects their actions today and in turn affects what happens in the future, just like those movies in the eighties with Michael J. Fox, it becomes a whole confusing mess with paradox on top of paradox that is difficult to sort out.  Or, to put it in the words of Scott Sumner quoting Paul Krugman: “it’s a simultaneous system.”

  1. June 15, 2014 at 12:23 pm

    Good post. What you say is sensible, and a very good starting point.

    But I think that money is different from other goods. A monopolist who supplies money by setting a rate of interest does not lead to the same sort of equilibrium as a monopolist who supplies refrigerators by setting a price of refrigerators.

    This is where I think we need to go next: http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/03/the-sense-in-which-the-stock-of-money-is-supply-determined.html

    • Free Radical
      June 15, 2014 at 6:33 pm

      Thanks Nick,

      I agree. 2 things. First, Yes! I had read that post and it probably had a big influence on what I wrote here but I’m glad you made me read it again because I renoticed this part.

      “It is not determined by the demand for money. P and Y will (eventually) adjust until the quantity of money demanded equals the quantity of money created by the supply (function) for money and the demand for loans. The supply (function) of money, and the demand for loans, together determine the quantity of money created, and that quantity created (eventually) determines the quantity of money demanded.”

      That’s exactly how I see it. With that in mind, I have been being sloppy with “demand for money.” By that I basically just mean “some function which determines the quantity of money for any given monetary policy.” But I agree that it is actually the demand for loans that is most important not the demand for money (although the demand for money may factor into it because when people find that money is very cheap and plentiful, one of the things they can do with it is pay back loans.)

      Second, I agree that it’s not like refrigerators, I was just trying to use a simpler example to show that monetary policy matters, it can’t just be demand-determined. I think it is analogous in the sense that a single actor, takes some kind of “demand” (as defined above) for granted and chooses a policy which causes some combinations of prices (price level, interest rate, inflation rate) and quantity of money. Of course, the way that the “demand” and policy interact to determine those things is more complicated than refrigerators since there are more things involved and this “demand” depends heavily on expectations about the future stance of monetary policy and stuff like that (although with refrigerators you do have the Coase conjecture to deal with haha).

  2. June 16, 2014 at 11:40 am

    And here is the post I did in response to Nick’s: http://monetaryreflections.blogspot.co.uk/2014/03/the-demand-and-supply-of-money-and.html

    But I agree with much of what you’re saying here. As a post-Keynesian myself, I get a little frustrated at the way endogenous money is sometimes represented, particularly by people like Keen.

  3. June 16, 2014 at 3:51 pm

    Here is what is meant by Post Keynesian endogenous money concept
    “Since reserve requirements are determined by a deposit count from a previous time period, and reserve accounts do not pay interest, demand for reserves is inelastic. Increasing or decreasing loans, and thereby deposits, for example, does change future reserve requirements, but cannot alleviate a current imbalance.Even with a lead system, as the U.S. had in the 1960′s, practical considerations of short term inelasticities of bank loan portfolios result in the same Fed policy of acting only defensively in the money markets (Basil Moore, Horizontalists and Verticalists, 1988). In other words, the Fed can only react to imbalances by offsetting them. The Fed does not have the option to act proactively to add or drain reserves to directly alter the monetary base unless it is prepared to accept either a 0 bid interest rate, or an interest rate coincident with a reserve deficiency at one or more member banks. However, as a reserve deficiency is automatically booked as a loan, the Fed’s only real option is to set the price its loan of needed reserves to the commercial banking system. This is the basis of the concept of endogenous money, the major theme of Post Keynesian monetary thought. (Pkmt survey, Cottrell, pkt archives)”


    • Free Radical
      June 16, 2014 at 7:16 pm


      Yes, but this matters.

      “the Fed’s only real option is to set the price its loan of needed reserves to the commercial banking system.”

      If they set the price higher, the banking system will “endogenously” create fewer loans and demand fewer reserves. If they set it lower, they will demand more.

      • June 17, 2014 at 6:44 am

        Yes, It matters mostly to people like Paul Krugman, so they can push their flawed monetary theories. In reality the influence is mixed concerning aggregate demand and output. Interest payments on treasury bonds are net income to private sector. Good luck.

      • June 17, 2014 at 7:01 am

        You could say that It depends on if the government is running a deficit, and that’s right. IMO the argumments you make in your article are not made with “good faith”. They are not wrong but your intentions are. It’s a word game mostly. The conclusion is that argument “monopolist can set either price or quantity but not both” is wrong. You arrived at wrong conclusion and reality is on my side.

      • Free Radical
        June 17, 2014 at 6:16 pm


        I’m not sure quite where your side is so I can’t tell if reality is on it, but I don’t think my argument as you characterized it (even though I don’t think it fully captures my point) is wrong. What you just called wrong is pretty standard stuff and you’re not giving me any alternate way of looking at it so I can’t really follow what you are saying. AS far as “good faith” goes, I don’t know what you mean by this. Part of what I said could be chalked up to “word games” but I basically acknowledged that and went on to explain why the fundamental point of Keen and the “endogenous money” crowd, namely that the quantity of money is determined by demand alone (and not supply or anything relating the central bank that is in any way like a supply curve) is nonsensical. Demand matters and CB policy also matters and whether you model it as the CB setting the quantity or the interest rate makes essentially no difference, at least in most cases. I don’t think there is anything word-gamey about that.

  4. June 16, 2014 at 4:22 pm

    “Did you spot it? Here’s a hint: a monopolist doesn’t have a supply curve. Does that mean the monopolist’s quantity is determined only by the demand curve? No, because the monopolist can control the price. But wait! says the smart kid in the front of the class. If he doesn’t have a supply curve, and he is facing a given demand, and he controls the price, then isn’t he effectively choosing a quantity? Like, couldn’t we just as easily say that he controls the quantity and the price is determined by the demand curve given that quantity?”

    Monetarists had money supply targets during Paul Volcker and It was a total failure. It hasn’t been tried since then again. If you are saying this monopolist has a supply curve, I say: you might be right in a sense. But what do you do next? Start controlling money supply? So this talk is bunch of empty boxes like Nick Rowe says sometimes 🙂

    • Free Radical
      June 16, 2014 at 7:20 pm

      I’m not arguing about what the Fed should target, I’m just arguing that what they do matters. And, for that part I wasn’t saying that they have a supply curve, just that they must choose a point along the “demand” curve just like a monopolist. At that point I have a short-run “demand” in mind. I said there was a thing like a supply curve in the long run, that probably made things a bit confusing.

  5. Tom Brown
  6. Tom Brown
    June 17, 2014 at 5:46 pm

    BTW, I’d even put up a very amateurish post on Nick Rowe’s post when he first posted it, just to help myself understand it better:


  7. Tom Brown
    June 17, 2014 at 5:48 pm

    … and now I’m linking to your post here in a question to Jason Smith (I don’t think he’s using exogenous and endogenous in precisely the same way):


  8. Tom Brown
    June 17, 2014 at 6:10 pm

    … and here’s Frances Coppola sounded a little frustrated, but nonetheless amusing Mark Sadowski, regarding Sumner’s views of endogenous and exogenous:

    “Typically, Sumner simply avoids the problem by ignoring the endogeneity and focusing on the exogenous “envelope” which constrains endogenous monetary base creation and interest rates. He’s very “macro”….sometimes I wonder if he realizes that woods are made of trees.”

    http://www.themoneyillusion.com/?p=26468#comment-326468 (Mark relates there how her quote make him laugh).

    I thought that was amusing too, plus I learned a little bit how to decode “Sumner-ese.” She said it partly in response to this comment from Sumner about Rowe’s “The sense in which…” post that you link to here:

    “Nick Rowe has a new post that argues the money supply is fully exogenous, even when the central bank is targeting interest rates.”


    I shared her frustration at first (before my lesson in Sumner-ese from Mark and Frances) since Nick repeatedly made statements like this in both his post and the comments:

    “The supply (function) of money, and the demand for loans, together determine the quantity of money created, and that quantity created (eventually) determines the quantity of money demanded.”

    So it’s “together” … “in conjunction with,” “both”, etc, not “fully” one or the other. 😀

    (BTW, that’s exactly how Mishkin puts it in his Money and Banking textbook too, but I’m sure you already know that).

    • Free Radical
      June 17, 2014 at 10:57 pm


      As usual, lots of good stuff to work through here, will look at your post more carefully and comment. In short: yes, I think you are grasping the main point that Rowe and Sumner and I are all driving at (though I have to look more carefully at Rowe, he likes to purposely say things in different ways to try to make them compatible with different people) which is this: “So it’s “together” … “in conjunction with,” “both”, etc, not “fully” one or the other. :D”

      You put it much more succinctly than I did. I might have gotten a little too cute with this one.

  9. Tom Brown
    June 18, 2014 at 5:57 am

    Mike, I read this on Noah Smith’s blog today:

    “As for “heterodox” economists, the bald fact is that many of them are just political hacks (cue explosion in comment section). Take “Austrian economists”, most of whom mix right-wing politics and econ theorizing like…well, similes fail me. But boy do they mix em. “Post-Keynesians” are somewhat less wedded to the political left, but still much more political than the mainstream folks. And MMT people…well, they’re just waiting for their Lord Xenu to return to Earth and cleanse the unbelievers, or something.”


    • Free Radical
      June 18, 2014 at 6:16 pm

      Haha, well it’s hard to argue with that. I might point out that mainstream economics does have it’s share of political…what’s a nicer word for “hack?” At any rate, it’s difficult to completely separate politics from economics but heterodox schools do seem to be particularly difficult in this respect. This, of course, from a guy with an econ blog with a decidedly political name (it was originally more of a political blog), so I’m not shy about my politics. But even I, who agree mostly with their politics, have well documented my frustration with Austrians (and now I’m going down the Post-Keynesian rabbit hole so that should be fun). For the record though, I suspect that Noah thinks Post-Keynesians are not as bad because he leans more to the left.

  10. Tom Brown
    June 20, 2014 at 12:37 am

    Mike, as you might expect Jason looks at the endogenous vs exogenous question in (what appears to me to be) a very different way:


    • Free Radical
      June 20, 2014 at 1:28 am

      P.S. Also, I don’t understand his model so saying this is going out on a limb a bit but I am highly skeptical that in his model everything is endogenous. A model in which everything is endogenous would be quite difficult (frankly it might be impossible but can’t say for sure) to construct and if you did so it would probably be trivial. For instance, you can’t say anything like “when X changes in a certain way Y changes in a certain way” if there is no exogenous X.

      • June 20, 2014 at 2:52 am

        The universe is an example of such a system.

        Joking aside, the idea is that the base allows the economy to grow which influences how much base growth corresponds to a given amount of economic growth.

        It’s a simultaneous system. Money doesn’t have any value except in relation to GDP.


        Another example of this is electromagnetic radiation. A changing electric field creates a changing magnetic field which creates a changing electric field, etc

        In this case the initial conditions are “exogenous” (along with shocks), but the future evolution of GDP and MB then determine each other.

      • Free Radical
        June 20, 2014 at 3:01 am

        “In this case the initial conditions are “exogenous” (along with shocks), but the future evolution of GDP and MB then determine each other.”

        Yes, you beat me to the punch haha. I actually mentioned in a recent post that in the real world everything is endogenous but I faithfully excepted the initial conditions and the laws of nature. But this is an important distinction in the current context. It’s quite clear that you can have a model where only the initial conditions are exogenous but that is far different from everything.

  11. Nathanael
    June 29, 2014 at 5:53 pm

    You actually can’t treat money as exogenous in any useful economic model, *because commercial banks print money* and so do ordinary people in response to various situations. (I do every time I write a check.)

    Treating money as exogenous therefore requires treating banks (at least) — and probably ordinary people too — as exogenous, and I can’t think of any reasonable part of the economy which can be modeled that way.

    Jason Smith is correct: you need a simultaneously evolving system model. They’re mathematically very annoying to work with, but you really have no option.

    • Free Radical
      June 29, 2014 at 8:32 pm


      Your comment amounts to an expression of your opinion that any model where money is exogenous is not useful but I disagree with that opinion. I suspect that you are not trying hard enough to see the usefulness of them but there is probably no use in arguing our differing opinions on this matter. But the point is that you can slap a process of “endogenous” money creation into the model but there will still be some form of monetary policy that is exogenously controlled by the central bank and (depending on the process) you are likely to end up with a model in which the CB’s “exogenous” action determines the money supply via whatever mechanism you choose, or in other words, it will be a lot like saying that money is exogenous. Now there may be some interesting insights that come from better understanding that mechanism and that is what I’m trying to work on here. But there is a lot of confusion and misdirection surround issues like “exogenous” vs. “endogenous” or “demand determined” vs. “supply determined.” These are not the proper points of contention.

      Ordinary people don’t print money. When you write a check, you are just spending the money in your checking account that the bank created. I cannot create a checking account for you because I am not a bank. If I tried and you wrote a check on that account and somebody accepted it, their bank would not let them cash the check because I am not a bank and don’t have the legal authority to create that kind of credit. The fact that there is a nonbank person involved in the creation of the credit does not change the fact that the bank must be involved and thus it is the banks which “create” the money (credit).

  12. Nathanael
    June 29, 2014 at 5:57 pm

    “if X follows Y, X couldn’t have caused Y ”

    Well, this is actually true. This is part of the definition of causation, actually.

    If X follows Y, then *either* Y caused X *or* Y and X were both caused by a third earlier thing Z *or* Y and X have no causal relationship and have nothing to do with each other.

    I can tell you a very good story for how
    – optimism causes
    – increases in credit money which causes
    – business production to boom which causes
    – higher demand for base money which causes
    – higher production and distribution of base money

    The root cause here, the Z, is “animal spirits”. 🙂

    • Free Radical
      June 29, 2014 at 8:38 pm

      That’s fine but the point is that when you have thinking, forward-looking agents making decisions that determine the things you are measuring, it is always “both Y and X were caused by a third earlier thing Z” For instance, the Fed announces it will target 2% inflation and it sets the short-run interest rate target at 1.5%. Then over time some quantity of deposits and reserves are created and output is created but it makes no sense to say that one of these things does or does not cause the other based on some measurement of them. They are all caused by Z which is the Fed’s policy (along with a bunch of other Zs). So Keen’s critique is not meaningful.

  13. Arirang
    March 25, 2015 at 12:05 pm

    You are referring to Keynes whenever you type Keens right?

    • Free Radical
      March 26, 2015 at 3:08 am

      No, Steve Keen. I put a couple links to the lectures I was referring to at the beginning.

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