Home > Macro/Monetary Theory > (More on) Endogenous and Exogenous

(More on) Endogenous and Exogenous

I might have gotten a little too cute in the last post and failed to make some of my simple points as simply as possible.  So let me take a different approach.

The status of something as either endogenous or exogenous is not a state of nature, it is a characteristic of a particular model.

There’s your thesis statement right up front in bold print.  Now I will try to explain with the simplest possible example.

Usually the first model we teach econ students is a simple model of consumer choice.  In this model, the price is taken for granted and we determine how many units a consumer would buy given the price and their MV schedule.  In other words, price is exogenous and quantity is endogenous.  We do the same thing with sellers, determining how many they would be willing to sell (or produce) for a given price.  Then we derive demand and supply schedules by determining how many people would buy/sell for any given price.  At this point, we have two models: a model of buyer behavior in which the price is exogenous and quantity demanded is endogenous and a model of seller behavior in which the price is also exogenous and quantity is also endogenous.

But then we put those two models together to determine a market price and quantity.  Now it is a different model!  We added the condition that Qs=Qd and this is only possible at a particular price.  The (equilibrium) price is now endogenous!  But we got there by assuming that all market participants treat the price as exogenous.

Now, if you ask: “well which is it, is price endogenous or exogenous,” you are asking a nonsensical question.  In the model which is designed to explain the determination of the price, it is (necessarily) endogenous.  In the model which is designed to explain the behavior of an individual, it is exogenous.  Neither model is “right” or “wrong” they are just useful or no useful, and in my humble opinion, both of these are quite useful.  It so happens that the latter is useful in constructing the former.

This is how economics generally works.  We start with the simplest questions we can and then we put them together to answer more complicated questions.  As you get more complicated (add endogenous variables to explain) you need more layers of reasoning and exogenous information.  In order to say how much someone would buy, you need a price and a MV schedule (or function).  Ditto for how much someone would sell.  If you want to make price endogenous, you need both the MVs of buyers and the MCs of sellers and you need the condition Qd=Qs.

So there is nothing inherently incorrect about constructing a model of the macroeconomy in which the quantity of money is exogenous.  We just have to understand that such a model does not explain the quantity of money.  Similarly, we can make a model that takes the price of money (the interest rate) to be exogenous and this allows us to say, to some extent, that we are “explaining” the quantity of money but then we aren’t explaining the interest rate.  And if our “explanation” of one or the other comes down to a downward sloping demand for money and a monetary authority who choses one or the other, it doesn’t matter much which one we say that they choose.

The real question is “is this model useful?”  When it comes to the standard model of money and banking, I say “yes, but it could be better.”  I agree that the mechanism which determines the quantity of money matters and a careful treatment of it is missing from mainstream models.  But it is not a question of being endogenous or exogenous, or even worse: “supply determined” or “demand determined.”  If you just say that the CB sets the price of money and not the quantity, and you are ignoring the fact that the quantity “demanded” depends on the price, then you are not saying anything helpful.  If you are saying that the CB controls the price of money but not the quantity, and you are recognizing that the quantity demanded depends on the price but only via the same downward sloping demand curve as in the model you are criticizing, you aren’t saying anything helpful either, you are just saying the same thing you are criticizing in a slightly different way.  If you are saying that money is “demand determined not supply determined” you don’t understand supply and demand.

If you want to say something useful, you need to add a dimension to the model that better explains how the price and quantity are determined and takes into account some additional information that is overlooked by both assuming that the CB sets M and the interest rate is determined by Md and assuming that they set the interest rate and M is determined by Md.  In short, if you want to make something endogenous, without just making something else exogenous, you have to add something else that is exogenous and plug it into the system with some kind of meaningful equation.

So you can make money endogenous simply by making the interest rate exogenous but this demonstrates nothing interesting.  Alternatively, you could make both M and i endogenous by adding something else like a (less trivial) money supply curve but then you would have to say where that comes from and why it makes sense to do it that way and why it matters.  Just declaring that in the “real world” money is endogenous gets us nowhere.




Categories: Macro/Monetary Theory
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