Economic Perspectives on Money


The 2008 financial crisis seriously brought into question the understanding of money and the monetary system by influential economists and regulators, which for approximately 40 years has been dominated by neo-classical economic thinking. But since the crisis increasing public debate on how to best understand money and the monetary system has opened up within other schools of thought, potentially leading to a paradigm shift in macroeconomics.

It has become clear that economists differ in their views on money, and different schools of thought have different perspectives on fundamental questions regarding money and the monetary system. Questions such as: What are the drivers and effects of the development in the money supply? Why and when is money created? And what effects do changes to the money supply have on the economy?

In this section we will give an overall presentation of the different economic perspectives on money and their main discrepancies. We will focus on the two opposing macroeconomic positions: the mainstream or exogenous position, where money is regarded as a neutral medium of exchange defined by the market but controlled by central banks, and the heterodox or endogenous position, where money is regarded as a state/institutional convention with the supply largely determined endogenously by the market.

Money in Mainstream (Neoclassical) Economics

The basis for the understanding of money in neoclassical economics is the commodity theory of money, and in textbooks money is generally treated as a neutral medium of exchange supplied exogenously by central banks.

That the emergence and existence of money is explained from the commodity theory of money is not to say that credit and banking doesn’t figure in mainstream models. It is acknowledged that the majority of money in circulation is bank deposits, but this money is seen as mere representations of the amount of commodity money, and is incorporated as part of the money supply through the so-called money multiplier model of money and banking.

The Money Multiplier Model

The multiplier model explains the total money supply as a function of the supply of base money by the central bank. The introductory example given for this theory often starts with a person depositing cash in a bank, e.g. £1000. As the bank knows that, on average, the customers won’t withdraw the whole of the £1000 all at once, the banks keeps a small ‘reserve’ of say 10% (£100), and lends out the remaining £900 to somebody who needs a loan. After receiving the loan the borrower then spends the £900 at a local shop which, after receiving the payment, deposits the received amount in another bank. At this point the quantity of money has increased to £1900 (the original £1000 that the first customer still has on deposit and the £900 that the shop dealer has now deposited). This process continues as the shop owner’s bank keeps 10% of the deposit in reserve (£90) and lends the remaining £810 out, and so on.

Every time money is re-deposited at a bank, new bank deposits (liabilities from the bank to the customer making the deposit) are recorded on the bank’s balance sheet and the money supply expands, continuing to the point where mere pennies are being re-lent, with the money supply topping out at around £10,000 despite the fact that there is only £1,000 of ‘base’ money (cash) in circulation.

The model can be visualised as a pyramid fig 2.22 (Jackson & Dyson, 2012). The cash (created by the central bank) is the base of the pyramid, and depending on the level of the reserve ratio, banks multiply the supply of money by re-lending cash again and again.

The money multiplier model of banking implies three things:

1. Banks have to wait until someone puts money into a bank before they can start making loans. Essentially they are mere intermediaries and react passively to what customers do. Deposits from customers therefore precede lending. This is the so-called Loanable Funds model of banking.

2. The central bank has ultimate control over the total amount of money in the economy. It can control the amount of base money by changing either the reserve ratio (the proportion of each new deposit that banks must keep in reserve) or the amount of ‘base money’ – cash (or reserves) – at the bottom of the pyramid.

3. The amount of money created by banks can never get out of control, unless the central bank allows it to, either deliberately or through negligence. The total amount of money in the economy is being determined by the supply of money by the central bank – therefore, the money supply is exogenous.

To summarise, the money multiplier model explains the level of money balances as a function of the decisions of the central bank as to how much additional cash or central bank reserves to release into use and the decisions of, or regulatory constraints on, commercial banks as to what proportion of this money can be prudently lent.

The Quantity Theory of Money

Mainstream economists generally explain the determination of the money supply with the money multiplier model, but when it comes to the long-run effects of changes to the money supply, mainstream economic models turns to another basic model – the so-called “quantity theory of money” as presented by (Friedman, 1969). This theory states that every given change to the money supply in the long run will lead to a proportional change to the price level in the economy – therefore, any given change to the money supply will only affect the nominal price level and have no real economic effects. Money and monetary policy is thought to be neutral.

The implication of the quantity theory of money is that monetary policy and demand led policies in general are ineffective instruments for influencing real economic development, in regards to creating jobs, increasing the amount of capital, etc.

For mainstream economic models based on equilibrium theory, the quantity theory of money is essential for explaining long run macroeconomic development, as well as the validity and operation of the models. As stated in the popular textbook Monetary Theory and Policy on monetary economics taught at many universities:

’Any theoretical model not consistent with a roughly one-for-one long-run relationship between money growth and inflation, though, would need to be questioned.’ (Walsh, 2010, s. 10)

Criticism of the Neoclassical Perspective on Money

As the money multiplier model and quantity theory of money form the basis for the teaching on the role of money in the economy in most mainstream textbooks, they are basically the only theories on the determination of the money supply most economists ever get familiar with. Nonetheless, they both face harsh criticism from many economists from other schools of thought.

In 1984 Charles Goodhart, who subsequently became a member of the Monetary Policy Committee and chief advisor to the Bank of England, described the money multiplier model used in textbooks as:

“…such an incomplete way of describing the process of the determination of the stock of money that it amounts to mis-instruction”. (Goodhart, 1984)

There are several points of critique to the model, all pointing to the lack of empirical evidence for the theory.

First of all, the money multiplier implicates a stable relationship between base money and broad money over time, but the evidence supporting this is weak. Rather the relationship between monetary base and broader money seems unstable and non-related (Coppola, 2014).

Secondly, the mainstream theories suggest that the development in the monetary base precedes lending decisions by the private banks, but rather the opposite seems to be true. Empirical analysis has been carried out on this topic. In a 1990 paper, Finn Kydland and Ed Prescott test for whether the monetary base (i.e. reserves and cash) increases before banks make loans, as suggested by the money multiplier theory, or afterwards, as suggested by the endogenous money theory. They found that:

“There is no evidence that either the monetary base or M1 leads the [credit] cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the [credit] cycle slightly.” [Our addition in brackets].

Third, in recent time the evidence for a long-run one-for-one correlation between growth in the money supply and inflation is weak and insignificant.

Yet despite the fact that many economists and central bankers have long acknowledged that the multiplier model faces severe shortcomings, it is still taught to students today as a factual description of how the monetary system operates.

Endogenous/heterodox view on money

In opposition to the neoclassical theory of money is what can be defined as the “endogenous theory of money”, which can be traced back to the work of Alfred Mitchell-Innes (1914), Knut Wicksell (1936), I. Fisher (1936), J.A. Schumpeter (1954) and H. P. Minsky (1992). Endogenous money theory is a broad non-homogenous group of theories, but common to the theories is a strong focus on the central role of private banks in the economy through their ability to create money and purchasing power through their lending.

As published by the Bank of England in 2014:

’Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created’ (McLeay, Radia, and Thomas 2014, s. 3)

Endogenous money theory explains how banks, rather than waiting for a depositor to come along in order for them to be able to lend, are able to lend as and when they want (within certain constraints).

If the bank needs central bank reserves to settle any payments that arise as a result of its lending, it will be able to borrow them either from the central bank or from other banks.

As Alan Holmes (then Senior Vice President of the Federal Reserve Bank of New York) put it in 1969:

“In the real world, banks extend credit, creating deposits in the process, and look for the reserves later.” (Holmes, p. 73)

The question then is: are banks restricted in making loans as a result of any potential inability to obtain reserves? In contrast to the money multiplier view of banking, according to endogenous money theory banks will almost always be able to obtain reserves – if not from the markets then from the central bank itself, which is required to “supply base money on demand” in order to stabilize and control interest rates.

Support for Endogenous Money Theory

The validity of the endogenous money theory has been confirmed by prominent central bankers and regulators. Before he became Governor of the Bank of England, Mervyn King wrote in 1994 that:

“In the United Kingdom, money is endogenous—the Bank supplies base money on demand at its prevailing interest rate, and broad money is created by the banking system.”

Also, in a 2011 speech, Vítor Constâncio, Vice-President of the European Central Bank, explained that:

“It is argued by some that financial institutions would be free to instantly transform their loans from the central bank into credit to the non-financial sector. This fits into the old theoretical view about the credit multiplier according to which the sequence of money creation goes from the primary liquidity created by central banks to total money supply created by banks via their credit decisions. In reality the sequence works more in the opposite direction with banks taking first their credit decisions and then looking for the necessary funding and reserves of central bank money.”

In conclusion, the endogenous money theory sees causality in the banking system occurring in the following way: private banks lend, creating deposits in the process. This increases demand for reserves in order to settle payments. The central bank provides reserves to banks on demand, thus accommodating the banking sector’s lending decisions. The fundamental implication of endogenous money theory is that it is commercial banks, rather than central banks, that determine the total amount of money in the economy.

Endogenous money theory thereby presents an opposing view of money to the money multiplier theory, which implies that the central bank determines the amount of reserves in the economy and controls the amount of money that banks create by altering the amount of reserves and setting reserve ratios.

Different Perspectives on Endogenous Money

The important shared insight of those who support endogenous money theory is that bank lending drives the money supply. There are, however, important semantic and analytical differences among different scholars in support of endogenous money theory.

Many Post-Keynesians consider it positive that private banks create money because they see the supply of money being driven by the demand for investments, thereby supporting the total amount of investments in the economy. Many post-Keynesians and especially so-called ‘Circuits’ basically see the supply of credit as being determined by the productive capacity of the economy, and largely regard the money creation process in the private banking system as a natural part of a capitalistic system (Lavoie, 2015).

Another more recently successful school of thought also applying endogenous money theory is Modern Money Theory (MMT). When it comes to securing enough finance for investments, MMT regards all kinds of money creation as ultimately dependent on support from the sovereign authority. This means that for any agent to be able to issue money, it needs legal and other supports from government to have that money accepted. MMT’s analysis tends to focus on the final, de facto control that rests with government, and therefore places less emphasis on the role of private banks and their interaction with the non-financial sectors relative to monetary reformers.

Thus both Post-Keynesians as well as MMT scholars tend to disagree with monetary reformists such as Joseph Huber who have advocated limiting the ability of private banks to create money. Reformists on the other hand would argue that Post-Keynesians and MMT scholars leave out important empirical aspects of the money creation by private banks.

Firstly, banks tend to finance mortgages rather than lending to small enterprises and other genuinely productive investments, creating speculative housing bubbles in the process.

Secondly, banks tend to create too much money in ‘boom years’ and not enough during recessions.

When it comes to considering MMT, one counter-argument from money reformists would be that MMT often leaves out the question of the profit from the privilege to create money – seigniorage. The MMT scholars may be theoretically right that nation states with their own fiat currency can’t go bankrupt as they are able to pay excessive interest by printing money, but the interest payments still have distributional effects by distributing money from taxpayers and future generations to money-issuing private banks; a redistribution which could be significantly reduced by letting the state issue its own fully liquid state-backed digital money to the private sector.


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