Endogenous money theory

In post-Keynesian economics, endogenous money is the term used to convey the view that the quantity of money in an economy (conventionally, and by this account misleadingly, termed the money supply) is determined endogenously—that is, as a result of the interactions of other economic variables, rather than exogenously (autonomously) by an external authority such as a central bank.

The theoretical basis of this position is that money comes into existence driven by the requirements of the real economy and that banking system reserves expand or contract as needed to accommodate loan demand at prevailing interest rates. This theory is based on three main claims:

'Loans create deposits': for the banking system as a whole, drawing down a bank loan by a non-bank borrower creates new deposits (and the repayment of a bank loan destroys deposits). So while the quantity of bank loans may not equal deposits in an economy, a deposit is the logical concomitant of a loan – banks do not need to increase deposits prior to extending a loan. While banks can be capital-constrained, in most countries a solvent bank is never reserve-constrained or funding-constrained: it can always obtain reserves or funding either from the interbank market or from the central bank. Banks rationally pursue any profitable lending opportunities that they can identify up to the level consistent with their level of capital, treating reserve requirements and funding issues as matters to be addressed later—or rather, at an aggregate level. Therefore, the quantity of broad money in an economy is determined endogenously: in other words, the quantity of deposits held by the non-bank sector 'flexes' up or down according to the aggregate preferences of non-banks. Significantly, the theory states that if the non-bank sector's deposits are augmented by a policy-driven exogenous shock (such as quantitative easing), the sector can be expected to find ways to 'shed' most or all of the excess deposit balances by making payments to banks (comprising repayments of bank loans, or purchases of securities).

Central banks implement policy primarily through controlling short-term interest rates. The money supply then adapts to the changes in demand for reserves and credit caused by the interest rate change. The supply curve shifts to the right when financial intermediaries issue new substitutes for money, reacting to profit opportunities during the cycle. Even if the monetary authority refuses to accommodate such changes, banks can still increase reserves for loan demand through their own initiatives.

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