This week’s macroeconomics class dealt with the question whether central banks set the interest rate or the money supply. According to the standard undergraduate macroeconomics textbook, the central bank sets the supply of money and can expand and contract it through open market operations (Blanchard, Amighini, Giavazzi, 2013). To be more exact, it is acknowledged that the central bank has full control only over the monetary base, which includes currency in circulation and bank reserves. But because the monetary base determines the money supply via the so-called money multiplier, it is generally said that the central bank increases the money supply if it increases the monetary base and decreases the money supply if it decreases the monetary base. The standard explanation is normally accompanied by a diagram of the ‘money market’ with a vertical Money Supply schedule, as shown below. Such a vertical line is equivalent to saying that the Money Supply is exogenously determined, because it does not depend on the interest rate.
However, when taking a closer at look what central banks actually do, one might be surprised that central banks rarely choose the supply of money deliberately. On the contrary, the money supply need not be fixed because central banks target the short-run interest rate instead. In the UK, for example, this is called the official Bank Rate, set by the Bank of England’s Monetary Policy Committee. The current Bank Rate is 0.25%. It was last cut in August from 0.5% and the next decision by the Monetary Policy Committee whether to revise or maintain the Bank Rate is going to be due on 3 November (BoE, 2016). A major implication of interest rate targeting, as practiced by the Bank of England, is that the money supply is endogenous, i.e. it is determined within the system rather than outside the system. Hence our Macro lecture revisited the theory and introduced the more realistic endogenous money story this week. It is broadly based on the undergraduate endogenous money teaching model by Fontana and Setterfield (2009). The following diagram summarises the exact mechanism of the endogenous money supply process.
First, the central bank sets the short-run interest rate to a certain value, say i1= 0.25% as in the UK at the moment. At this rate it fully satisfies commercial banks’ demand for base money. Graphically this is shown through a perfectly elastic base money supply schedule in yellow. In words, one might say that the central bank is a price-maker and a quantity-taker.
In the second step, commercial banks pass this interest rate of the central bank on to households in the credit market. Thereby the interest rate charged by commercial banks is called the bank loans rate (rL1). It is set as a fixed mark-up over the short-run interest rate charged by the central bank in order to make a profit on their loans to households. Again, because commercial banks set a certain loans rate rather than the supply of credit, they are price-makers and quantity-takers with a perfectly elastic credit supply schedule in blue (CS). They fully satisfy the demand for credit by creditworthy households at the going loans rate. Next we need to look at the demand for credit (CD). It depends negatively on the commercial banks’ loans rate. When the loans rate is high, there is little demand for credit. Conversely, at a low loans rate demand for credit is going to be high. Ultimately, the equilibrium quantity of credit (C*) created in the credit market is at the point where the downward sloping credit demand schedule of households and the perfectly elastic credit supply schedule of commercial banks intersect; that is Point A.
In the third step, the credit market equilibrium feeds into the economy. This is because of the circular flow of the loans obtained by households. They are going to be receipts of someone else who, in turn, deposits the money in a bank account. This is why bank loans create bank deposits one-for-one in the diagram. This is captured by the Loans Deposit (LD) schedule in the panel on the bottom right.
In the fourth step, these bank deposits need to be supported by monetary reserves as a precautionary means for reducing the instability of fractional reserve banking and avoiding public panics etc. The exact Deposit Reserves schedule is going to depend on the reserve requirements mandated by the central bank. Yet because it is going to be a fraction of the overall bank deposits created, it will be a straight line proportional to the Loans Deposit (LD) schedule.
In the fifth and final step, we are back in the upper left corner of the diagram, which is the market for monetary reserves. Having determined the reserve requirements of the commercial banks, the central bank will supply this amount of money but at the price of the central bank (the short-run interest rate i1).
In sum, the exogenous money supply approach taught in introductory macroeconomics at undergraduate level states that the central bank sets the base money and, via the money multiplier, the money supply. This then determines the interest rate. In contrast, the endogenous money supply approach, we are now learning in intermediary macroeconomics moves closer towards reality and what central banks, like the Bank of England, actually do. With the endogenous money supply approach, we acknowledge that most central banks target the interest rate. This, in turn, determines the volume of loans in the economy and ultimately the money supply and the base money. As Carlin and Soskice (2006) point out, the chain of causality in the endogenous money supply approach is reversed and approximates the actual behaviour of central banks better than the exogenous money supply story. In fact, Fontana and Setterfield use their endogenous money model together with a model for pricing, production and the labour market to explain the mechanisms underlying the global financial crisis. They show that their model based on endogenous money supply captures the credit crunch together with its adverse impacts on output and unemployment.
Thanks for reading!
Blanchard, O., Amighini, A., & Giavazzi, F. (2013). Macroeconomics: A European perspective. Harlow: Pearson.
BoE (2016). Monetary Policy Committee Decisions, Minutes and Forecasts. Available at: http://www.bankofengland.co.uk/monetarypolicy/Pages/decisions.aspx [Accessed 28 September 2016].
Carlin, W., & Soskice, D. (2006). Macroeconomics: Imperfections, institutions, and policies. Oxford: Oxford University Press.
Fontana, G. and Setterfield, M. (2009). Macroeconomics, endogenous money and the contemporary financial crisis: a teaching model. Int. J. Pluralism and Economics Education, 1(1/2), pp.130–147.