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Module Code: LUBS3430

Module Title: Modern Theories of Money and Monetary Policy

Module Leader: G. Fontana

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Discuss the two main tenets of the endogenous money theory, namely that ‘loans create deposits’
and that ‘deposits generate reserves’ and their policy implications. Illustrate your answer using
relevant diagrams and/or a balance sheet approach
Endogenous Money is one of the most central theory of Post Keynesian economics (Palley,
2002). According to the theory the money supply is endogenously defined via the demand for
bank credit (Goodhart, 2017). The focus of this essay is to discuss the endogenous money theory
by deriving Fontana’s 4 panel diagram. The framework of this paper will be to explore the
macroeconomic policy implication derived from the theory.
The Horizontalist theory of money rejects Monetarist theory and its policy conclusions. It
suggests a different theory of money and banking based on the notion that 'loans create deposit’
and 'deposits generate reserves' (Moore 1988) or in other words money is considered credit as
it is generated when banks gives out loans. Furthermore, where money supply is concerned,
rather than being defined by the central bank according to this theory the central bank programs
the interest rates and lets the money supply adjust accordingly (Fontana and Setterfield, 2008)

‘Loans create deposits, deposits create reserves’

(Fontana and Setterfield, 2008 pp.147)

Following from that according to Post Keynesian theory, money supply can be explained through
a 4-sided diagram(Fig.1) which also gives raise to the two major tenets. The upper right panel
indicates the credit market, where firms, consumers and commercial banks demonstrate the
demand and supply of bank loans, respectively. The supply of bank credit at CS alongside
the demand for bank credit at CD , which is a decreasing function of the bank loans rate,
(rL) illustrates at point A the total volume of produced credit at C1(Fontana and Setterfield,
(2008).
Consequently, two of the main insights of endogenous money theory, namely, that bank loans
create bank deposits (LD line) and bank deposits generate the demand for monetary
reserves (DR line) are most prominent at the two lower panels. Hence, the credit market
equilibrium at A indicates, through the LD line, the new bank deposits (BD1) supply and hence
through the DR line commercial banks’ demand for reserves( R1). However, the LD line
indicates the commercials’ bank balance sheet constraint and it is based on the assumption
that banks hold their liabilities fixed.
Furthermore, when drawing on the diagram, assuming a pure credit economy with only one
bank, firms need to first finance their wage and material costs before production can commence.
Realistically, banks document loans to creditworthy organizations on its assets, and deposits of
organizations on its liabilities. These deposits are then applied by firms to cover salaries for
labour services (Fontana, 2009). Hence, row 2 on Table A, indicates that deposits are transferred
from firms to households and hence justifies that loans do create deposits.

(Fontana, 2009 pp.89).

Lastly, the upper left panel illustrates the process of the market for monetary reserves. The
supply of reserves (RS) represents how the central bank fulfils the demand for reserves
by commercial banks at its short-term real interest rate (i1) . Ultimately, when the supply of
reserves adjusts to correspond to the demand for reserves ( R1 ) that was generated by the
new supply of bank deposits ( BD1 ) the market for monetary reserves is in equilibrium (B) .
The second tenet of the Horizontalist theory of endogenous money, namely that ‘deposits
generate reserves’ can be explained through an analysis of the balance sheets of the commercial
and the central banks (Table B ) As suggested by Fontana (2009) if a household demands £10
million of deposits at (BD1) to be converted into cash, realistically, the commercial bank
acquires this amount of cash from the central bank. In addition, the commercial bank notes that
the bank deposits acceptability as a method of payment is based on on the households
confidence that deposits can always be transformed and withdrawn in cash for purchasing goods
and services. Consequently, this implies that the commercial bank requests monetary reserves
(R1) from the central bank as it is required to preserve a certain amount of monetary reserves
to deposits ratio. As suggested there is a reserve requirement ratio (the slope of the DR) that
determines the amount of reserves held at the central bank .It can therefore be suggested that the
higher the deposit ratio the higher the level of generated reserves.
 (Fontana, 2009 pp.95)

Policy implications

Following form that, as discussed in the previous section the central bank supplies monetary
reserves on demand to protect the acceptability of bank deposits as a method of payment.
Advocates of the Post Keynesian theory suggest that, where the central bank has no other
option but to accommodate the demand for reserves of the commercial bank. Alternatively,
that would lead to a decrease of public confidence and a consequent breakdown of the
financial system and possibly of the whole economy (creates a credit crunch). Realistically,
it sets the short-run nominal interest rate at which reserves are extended to the commercial
bank which is also the short-run interest rate that the commercial bank uses to manage its own
deposits rates as well as lending .The central bank fixes the short-run interest rate in
accordance with its political or economic objectives, such as the achievement of a
particular target rate of inflation (Fontana 2006)
The following equation (1) AD= ND+ cf( rL) is in line with the hypothesis that a rise in
the bank loans rate, by increasing the cost of borrowing for households and firms
and hence reducing their confidence and ability to borrow, will result in a decrease of the
total expenditures households and firms are accountable for , and therefore a reduction in
aggregate demand for goods and services(Fontana and Setterfield, (2008).
The value of the short-run interest can also be linked to the state of the market for goods through
(2) i=g(P ), g ‘>0 which is a monetary policy rule presenting the processes of the central
bank’s monetary policy (Fontana and Setterfield, 2008). In other words, monetary policy rules
show the response of real short-run interest rates to fluctuations in the state of the economy.
That implies that there are many different types of monetary policy rules. The central bank may
decide to target only a single (e.g. inflation) or various economic agents (e.g output,
employment and inflation). In has been a common practice for many industrialized
economies, to make the central banks responsible for tasks such as meeting a certain inflation
level through manipulation of the real short-run interest rate. Drawing on that, according to
Fontana and Setterfield (2008) equation 2 illustrates a very basic kind of monetary policy rule
correspondent to the exercise of inflation targeting , in which the real short-run interest rate
changes in response to changes in the price level (Sawyer and Arestis, 2006).
If we assume that the general price level (P) goes up, according to Fontana and Setterfield
(2008) policy rule in equation 2, this will result in an growth in the short-run interest rate (i )
administered by the central bank. As commercial banks define their bank loans rate (Lr) as a
constant mark-up (m) over the short-run interest rate, consequently increasing the short-run
interest rate will result in a higher bank loan rate (Fontana and Setterfield, (2008). This
indicates that borrowing will now be more expensive for firms and households allocated to the
non-bank private sector. Unfavourable repercussions for aggregate demand will follow as cost of
borrowing to finance investment is greater hence, the demand for investment goods will fall for a
given expected rate of return. Parallelly, a rise in the short-run interest rate and hence in the bank
loans rate suggests that it is also more costly for households to borrow money for the
purchase of goods and services. That will reduce the willingness and ability of households to
borrow, hence, consumption spending will shrink, by presumption that will also result in fall in
inflation and a higher rate of unemployment (Sawyer and Arestis, 2006). In addition, seeing as
both investment and consumption are instruments of aggregate demand, in this situation an
increase in Lr will result in lower aggregate quantity demanded due to the opposite
correlation between thee aggregate demand and the bank loan rate in in equation (2) (Fontana
and Setterfield, (2008).
In summary, according to the Post Keynesian schema in the financial system money is
considered credit. Drawing on the 4 panel diagram it is realist to suggest that the higher the
amount on loan given out by banks the higher the level of money that is later going to be
deposited by households. Furthermore, the panel also justifies that deposits generate reserves, as
the higher the level of deposit the higher the reserve ratio requirement by the central bank. The
theory proposes the interest rate as the main instrument to manipulate the market variables and
therefore suggests it to take part in the creation of policies.
Instability is determined by mechanisms within the system, not outside it; our economy is
not unstable because of its shocks by oil, wars or monetary surprises, but because of its
nature.

It has been long argued that the economy is inherently unstable, and that left to itself it
will go through periods of socially costly booms and recessions repeatedly , with recurrent
intervals of maintained high levels of unemployment. As previously suggested market economy,
by its very nature, could create such an environment independently of outside disturbances. The
focus of this essay is to critically discuss Minskys (2008) financial instability hypothesis and to
suggest advantages and drawbacks related to his assumptions
Initially, Minsky places finance at the heart of his analysis. The main presumption is that
investments generate higher profits than debts. As the theory also suggests uncertainty, the
validity of this assumption is thus questionable(Sawyer and Arestis, 2006).
Following from that, the main implications of the theory arise in Figure 3. Growth in
expected profits results in rise in both internal and external investments. Consequently, the
greater indebtedness is related to a decrease in safety margins which in turn leads to growth in
the economy and respectively a more fragile financial system (Sawyer and Arestis, 2006).

(Sawyer and Arestis, 2006 pp.160)

The effect of an unexpected rise in profits on investment is illustrated on Fig 10.3.
Initially, the profit growth results in rise in the accessible internal funds at Qi, and hence
explains the rightward shift of the equilateral hyperbola at Qi PI, of the level of internally
financed investments Ii, and of the borrower’s and lender’s risks starting from Ii. In addition
point 0 indicates the internally financed growth in effective investments from Ie0 to Ie0’
.Following the installation of investment goods, profits are increased , and therefore that gives
rise to two additional outcomes (Sawyer and Arestis, 2006).
 On the one hand, the initial demand price for investment goods is boosted . On the other,
the confidence in the future debt obligation fulfillment goes up, increase in profit is considered
constant , hence lender’s and borrower’s risks is decreased. Consequently, there is an increase in
effective investment ( Ie0- Ie1 in Figure 10.3) which is now funded by indebtedness (Sawyer and
Arestis, 2006).
According to Minsky there are two disadvantages of the boom. As confidence increases,
safety margins decline. Firms’ debt commitments increase more rapidly than profits, and hence
go above the generated profits. Indebtedness not only grows fast, but stimulates the growth of
short-term debt, which requires faster repayment of principal than the profit made by the firms
operations (Sawyer and Arestis, 2006). Taking into account the assumption of a future profit
realization , firms’ financing is now based on debt not only for the principal (speculative) but
the interest payments (ultraspeculative financing). It is realsitc to suggest that the fulfillment of
debt commitments is financed by the growth in indebtedness. From being originally stable, the
financial system becomes fragile. In addition, the second drawback, namely the growth is held
constant for a certain time interval it can be argued that the central bank is guided towards
deflation and hence a higher interest rate is set (Sawyer and Arestis, 2006).
Minsky argues that the interests rate ends the boom, as the investment– profit–investment
sequence is converted in a downward spiral and is what sets off the financial crisis: firms are
unable to realise their debt commitments. The unexpected rise in the price of funds results in an
unexpected fall in profits which are already insufficient . To meet the inherited debt
commitments would therefore demand an increase in indebtedness(Sawyer and Arestis, 2006.
The main objective for organizations (shared by their financiers) under these
circumstances, is to fulfill inherited debt commitments and to minimize indebtedness rather than
realise further investments. The only way reduce debt is by the sale of assets, which after the
boom are mainly illiquid assets. These assets, however, undergo a fall in the price which, by
reducing the net wealth of firms and financial intermediaries, gives rise to the need to shrink
indebtedness through asset disposal which in turn would lead to a further fall in assets prices.
Following form that, the decrease of capital asset prices increases the fall of profits and
investments. Minsky argues that the crisis turns into an asset price as well as a profit deflation
(Minsky, 2008). Given the situation, a period of economic tranquility will reactivate the process
described in the above sections, namely , the system will go through another expansion, a
speculative growth, a financial crisis and lastly debt deflation, as well as a deep depression.
Drawing on Minsky’s analysis it is realist to suggest that the economy is indeed fragile by
design due to its nature and the way it operates (Calomiris, 2014). It could be suggested that
outside shocks (wars, oil prices) have substantial impact; however, they are not the main cause
behind the fragility of the economic system rather they are outside factors that fuel the already
existing instability. As Berument and Ceylan (2010) suggest oil price shocks do not appear to
impose statistically significant effects on some economies rather they observe that output
decreases with positive oil supply shocks and increases with positive oil demand shocks which as
mentioned above does affect the economy but is not what cultivates a recession.
In addition, it is also realistic to suggest that the level of authenticity of the above
discussed hypothesis is determined, to an extent, by the level of appliance it has in real life
conditions.
 When making a comparison between the Southeast Asia crises of 1997–98 and the
recession in 1977–96. It could be suggested that these crises have some common characteristics.
They were provoked by a stimulated environment of high confidence and speculation which was
by itself was a result of financial deregulation. Nevertheless, the crisis of 1977–96 were balance
of payments induced crises and those in 1997–98 were currency induced. On the one hand, the
crisis of 1997–98 was provoked by devaluation due to the change in capital flow, a consequence
of the imbalance between foreign indebtedness and foreign reserves. On the other hand, the
recession during 1977–96 was due to a consumption growth which was a result of the balance of
payments deficit. Nevertheless, in both cases, the two crises periods coincide with Minsk’s
theory.
However, when trying to apply the FIH to the subprime mortgage crisis in 2007-2008 for
example, on the one hand, the accuracy and relevance of Minsky’s broad perspective in terms of
dynamics of capital are quite transparent. On the other hand, the 2007 crisis has diverged in
considerable ways from Minsky’s financial-cycle instability hypothesis.
For one thing, Minsky viewed downturns as caused by investment cycles, not by
housing-price collapses. Realistically, his attention is mainly on non-financial and financial
organizatons, not on households. Furthermore, Minsky argues that downturns can be controlled
through regular governmental activity or in other words conducting lender-of-last-resort activity
and high government expenditures can restrict damage to the real economy by reconstructing
stability and reinforcing aggregate demand (Dymski, 2009).
However, despite being argued weather the 2007 crisis is a ‘’Minsky’’ Moment, it is
realist to suggest that the theory is applicable to an extent. First, real estate could be considered
as the investment agent in the situation and relatively safe too, especially when compared with
the dotcom investments. Furthermore, fragility is injected into the system by banks that bundle
mortgages into mortgage-backed securities. These loans are then used to purchase more
mortgage bundles supporting Minsky’s notion that further investment is financed with borrowed
money. In addition, investors’ motivations in purchasing such securitized assets were driven by
optimistic expectations under conditions of expansion, as described by Minsky (Kaboub and
Todorova, 2008)
As suggested by Minsky the financial system is inherently unstable (Sawyer and Arestis,
2006). Financial crises are not the result of irrational euphoria or outside forces, but rather deep
structural imperfections that are characteristic for to capitalist structure. The framework of a
capitalist economy is observed through growth in fragility over a period of growth and prosperity
and an endogenous process results in a financial and, consequently, economic instability. As
argued, however, it is realistic to suggest that although the theory fits and explains some previous
economic conditions such as the Southeast Asia crises it fails to provide an exhaustive
description of other conditions such as the 2007 subprime crisis. As inequality has been the main
structural cause of it, yet Minsky analyses is more concentrated in describing the economic
fragility through the gaps of the financial structure. Following from that, it can be argued that
Minsky’s analysis cannot be considered universal and unchangeable (Kaboub and Todorova,
2008)
 Due to the structural variations in the modern economy that have given rise to a new
shape of capitalism it might be plausible to suggest that the theory could now be regarded as a
complimentary in addition to being universal in previous cases. (Caverzasi, 2014)

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