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Literature Review

The main purpose of this report is to review the money creation process under two different theories, namely, Endogenous Theory And Exogenous Theory. This report also highlights the role of central bank under both these theories. The qualitative approach is used for evaluating the process of money creation under different theories. The report then proceeds with the changes in the nature of monetary policies under both the theories. Several scholarly articles, journals and other sources are reviewed to provide argument in the area of money creation under endogenous theory and exogenous theory.

The endogenous theory of money indicates that the money supply is determined through the interactions of economic variables. The main features of the endogenous theory is that the quantity of money is not determined by the central bank and it is not fixed (Dleidi 2018). The monetarists view the supply of money as endogenous whereas the structuralist view the money supply as exogenous (Twinoburyp and Odhiambo, 2018). Both the terms have been used vigorously by the scholars and economists. The endogenous view suggests the determination of money supply in the economy is based on the endogenous variables. When the money supply in the economy is determined by the changes in interest rates, fall in reserves and so on, it is said to be endogenous. In contrast, when the money supply is determined by the bank preferences for excess reserves, depositor preferences of holding money and the other economic variables does not affect the money supply, then it is said to be exogenous.

The endogenous theory states that the creation of money takes place due to the interaction of several economic variables such as output and the interest rates. Money is considered to be the center in macroeconomics. Palley (2017) examines the theory of endogenous money and provides information as to how it is different from the conventional theory of money supply. The endogenous theory discards the money multiplier method of money creation under conventional theory and focuses on the lending pattern of the financial institutions. The endogenous theory retains the long-term interest rates policy of liquidity preference theory. The paper revealed that the banking institutions are subjected to financial issues that restrict their lending activities.

The Post Keynesian theory identifies the casual link between the money supply and the bank lending. The structuralists also argue that the demand for credit and the reaction of monetary authorities have an influence on the money supply within the economy.  Deleidi and Fontana (2020) studies the endogenous and exogenous money theories as a review of political economy. The paper concludes that the Post Keynesian (endogenous) theory supports several propositions such as bank deposits are determined by the bank loans and they further determine the monetary reserves. The endogenous theory states that the creation of money takes place due to the bank lending activities. Bank loans create the bank deposits, which in turn creates the monetary reserves. The paper highlights the three important variables in the process of money creation which include bank deposits, monetary reserves and the bank loans. The research also reflects that the under endogenous theory, the quantity of money in the circulation is determined by the demand for loans in the economy. The commercial banks acts as the producer of money, according to the Post Keynesian Theory.

Monetary Policy and Money Creation

The fractional reserve banking refers to a process in which the banks are required to hold a fraction of their deposits as reserves (Haymond and Beach 2020). The central banks restrict the commercial bank to lend all deposited money with the bank. The commercial banks are required to maintain a cash reserves with the central bank. The excess reserves refer to the deposits that are in excess of the required reserves. The total reserves of the banking institutions include all form of bank deposits that are held in reserves. Under exogenous theory, the money supply is the sum of total currency and the demand deposits within the financial institutions. The total money creation under the Fractional Reserve banking system is calculated by using simple money multiplier.

According to the research conducted by Sieron (2019), the supply of money can either be endogenous or exogenous. It is dependent on several factors such as bank lending, reserve requirements, bank deposits and others. Deleidi and Levrero (2019) conducted the empirical and theoretical analysis of United States, to determine whether the money supply is the result of endogeneity of exogeneity. The paper utilizes the autoregression model to analyse the different variables affecting the money supply such as bank loans, bank deposits, monetary base and the level of economic activity. The findings of the study indicates that the supply of money is determined by the nominal level of economic activity and the lending activity which is supported by the endogenous theory.

 Fontana, Realfonzo and Passarella (2020) studies the monetary economics after the impact of great financial crisis. The paper concludes that several central bankers and the practitioners are of the view that the money supply is determined as stated in the endogenous theory. However, the theory neglects the dynamic process of money creation, circulation and the destruction of money. The endogenous theory does not support the key feature of capitalist economies as it is not explained as a logically and consistent theory.

The main objectives of the monetary policy it promote stable prices, maximum level of employment and the moderate long-term interest rates. Chi and Ji (2016) studies the monetary policy and the market structure under endogenous theory in a Schumpeterian economy. The paper analyses the impact of monetary policy on the firm size, economic growth and the social welfare within the economy. The findings of the paper reveal that the monetary policy has no long-run impact on the growth of economy. However the increase in the interest rate reduces the level of consumption, output and employment within the economy. Under the endogenous theory, the monetary policy plays an important role in the maintaining financial stability within the economy. The paper also indicates that the changes in monetary policies have negative impact on the economic growth in the short-run.

Cash Reserve Requirement

Tymoigne 2016, studies the monetary and fiscal operations by the government under the endogenous approach. The author emphasizes on the role of treasury in the monetary policy of the country. The monetary policy refers to the policy adopted by the central bank to control the quantity of money supply within the economy. The central bank aims to influence several macroeconomic factors including consumption rate, inflation rate, economic growth and overall liquidity (Hartmann and Smetts 2018). The increase and decrease in the interest rates and cash reserves by the central bank plays an important role in maintaining the price stability under the endogenous theory and exogenous theory. In the case of recession, the reduction in interest rates would increase the money supply in the economy. In such circumstances, increase in lending would result in increase in the general price level which will eventually lead to price stability. In case of inflation, the increase in interest rates will eventually reduce the bank lending opportunities and the supply of money will be controlled.

The cash reserve requirement plays an important role in the exogenous theory of money creation. The central bank controls the supply of money in the economy through increase and decrease in the cash reserve requirement (Xing et al. 2020). Under this theory, the money is created through the lending activities of the commercial banks. The central bank may increase the cash reserve requirement in order to reduce the flow of money within the economy and vice versa.  

Conclusion and Implications

The endogenous and exogenous theory of money supply is one of the most heated topics in the academic literature. The former theory states that the supply of money in the economy is determined through the demand for bank loans in the economy whereas the exogeneity means that the money supply is independent of demand. The endogenous money creation implies that the money is created through the interaction of different economic variables such as ban loans, bank deposits and interest rates. The exogenous theory states that the supply of money is determined by the activities of the external authorities such as central bank. The central bank of the country regulates the money supply in the economy through several monetary policies such as bank rate, cash reserve requirement with the central bank.

Under the exogenous theory of money supply, the monetary policy plays an important role in the level of money supply within the economy. The increase in cash reserve requirement would result in the reduction in money supply and vice versa. The study of empirical research on endogenous and exogenous theory suggested that either of the two theories can exist in reality. However, through the analysis of existing literature and the implications of central bank, it can be deduced that the exogenous theory of money supply is more relevant in the actual world. This is because the monetary policies of the central bank has greater implications on the supply of money.

References

Chu, A.C. and Ji, L., 2016. Monetary policy and endogenous market structure in a Schumpeterian economy. Macroeconomic Dynamics, 20(5), pp.1127-1145.

Deleidi, M. and Fontana, G., 2019. Money Creation in the Eurozone: An Empirical Assessment of the Endogenous and the Exogenous Money Theories. Review of Political Economy, 31(4), pp.559-581.

Deleidi, M. and Levrero, E.S., 2019. The money creation process: A theoretical and empirical analysis for the United States. Metroeconomica, 70(4), pp.552-586.

Deleidi, M., 2018. Post Keynesian endogenous money theory: A theoretical and empirical investigation of the credit demand schedule. Journal of Post Keynesian Economics, 41(2), pp.185-209.

Fontana, G., Realfonzo, R. and Passarella, M.V., 2020. Monetary economics after the global financial crisis: what has happened to the endogenous money theory?. European Journal of Economics and Economic Policies: Intervention, 17(3), pp.339-355.

Hartmann, P. and Smets, F., 2018. The first twenty years of the European Central Bank: monetary policy.

Haymond, J. and Beach, R., 2020. The Morality of Fractional Reserve Banking. Journal of Markets & Morality, 23(1).

PaLLey, T.I., 2017. The theory of endogenous money and the LM schedule: prelude to a reconstruction of ISLM. Brazilian Journal of Political Economy, 37(1), pp.3-22.

Siero?, A., 2019. Endogenous versus exogenous money: Does the debate really matter?. Research in Economics, 73(4), pp.329-338.

Twinoburyo, E.N. and Odhiambo, N.M., 2018. Monetary policy and economic growth: A review of international literature. Journal of Central Banking Theory and Practice, 7(2), pp.123-137.

Tymoigne, E., 2016. Government monetary and fiscal operations: generalising the endogenous money approach. Cambridge Journal of Economics, 40(5), pp.1317-1332.

Xing, X., Wang, M., Wang, Y. and Stanley, H.E., 2020. Credit creation under multiple banking regulations: The impact of balance sheet diversity on money supply. Economic Modelling, 91, pp.720-735. 

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