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Monetary Endogeneity and the Quantity Theory

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Monetary Endogeneity and the Quantity Theory Department of Economics Trinity College Hartford, CT 06106 USA http://www.trincoll.edu/depts/econ/ TRINITY COLLEGE DEPARTMENT OF ECONOMICS WORKING PAPER 14-02 An essay on horizontalism, structuralism and historical time* Mark Setterfield March 2014 Abstract Beyond agreement on the basic principles of money’s endogeneity, the development of Post- Keynesian monetary theory has been characterized by considerable dissent and debate. One important aspect of this debate concerns the shape of the credit supply curve in quantity of credit/interest rate space. The argument in this chapter is that that there can be, and to an extent already is, agreement that the horizontal credit supply curve is not a special case, and that the existence of an indeterminate dynamic credit supply schedule provides a general framework capable of accommodating both horizontalist and structuralist arguments. These arguments rest on the distinction between logical and historical time and, in particular, the claim that any construct (including, for example, a credit supply schedule) that is akin to a determinate long run equilibrium relationship is anathema to the methodological foundations of Post-Keynesian economics. J.E.L. Codes: E12, E42, E43, E51 Keywords: Endogenous money, horizontalism, structuralism, historical time, supply of credit * Prepared for L.P. Rochon and B. Moore (eds) Post-Keynesian Monetary Theory and Policy: Horizontalism and Structuralism Revisited, Edward Elgar, forthcoming Book title X. An essay on horizontalism, structuralism and historical time Mark Setterfield INTRODUCTION An essential feature of Post-Keynesian monetary theory is the principle of an endogenous money supply. According to this theory, commercial banks are retailers of credit who make loans on demand to credit-worthy borrowers at a price of their own making. This retail price of credit is established by marking up the wholesale price of credit – i.e., the rate at which commercial banks can, themselves, borrow, which can be thought of as the central bank’s discount rate.1 Given the commercial interest rate and the number of credit- worthy borrowers, the demand for credit thus determines the quantity of credit created by commercial banks, which in turn determines the aggregate money supply (the quantity of broad money in circulation). This process, through which loans create deposits, necessitates an endogenous supply of reserves by the central bank in order to ensure that the liquidity of commercial banks is maintained at all times. The central bank thus loses the absolute control over the quantity of reserves (and hence, via the traditional money multiplier, the total money supply) with which it is seemingly invested by virtue of its status as monopoly supplier of reserves to the banking system. Instead, the monetary system is characterized by the ‘reverse base multiplier’ or ‘money divisor’ process: B = (1/m) M (1) where B denotes the monetary base, M is the total (broad) money supply and 1/m – the money divisor – is the reciprocal of the traditional money multiplier (Lavoie, 1984, p.778; Rogers, 1985, p.243; Arestis, 1987, pp.5-6; Arestis and Eichner, 1988, pp.1009. See also Lavoie, 1992, pp.169-75). In equation (1), B responds endogenously to variations in M, which are determined (as described above) by credit-creation decisions made by the private sector. Of necessity, monetary policy thus becomes a matter of the Book Title 2 central bank determining the value of the discount rate. On these first principles, Post-Keynesian monetary theorists are essentially agreed. But beyond agreement on the basic principles of money’s endogeneity, the development of Post-Keynesian monetary theory has been characterized by considerable dissent and debate. One important aspect of this debate concerns the shape of the credit supply curve drawn in quantity of credit/interest rate space.2 A stylized characterization of the issues at stake runs as follows. According to horizontalists, the commercial interest rate can be regarded as exogenous to the credit market. As the quantity of credit expands, then, it does so in a ‘fix price’ market, thus yielding the perfectly elastic or ‘horizontal’ credit supply schedule from which the tradition takes its name.3 But horizontalism has been charged with being a special case. For example, Davidson (1991) argues that any non-zero elasticity of the credit supply curve suffices to make the supply of money endogenous.4 The perfect elasticity posited by horizontalism is, therefore, sufficient for endogeneity, but is not necessary. The more general case is captured by structuralism. Structuralists posit that interest rates are determined endogenously and will rise as the quantity of credit that is endogenously created within the economy increases. This gives rise to an upward sloping credit supply schedule in quantity of credit/interest rate space.5 Horizontalists have objected to the designation of their theory as a ‘special case’, however, critiquing the processes that structuralists hold accountable for the endogeneity of the interest rate. The result has been a heated debate between the two traditions concerning the ‘correct’ shape of the credit supply curve. Although some authors now refer to this debate in the past tense (Wray, 2006, p.271), others regard it as very much alive (Palley, 2013). As a result of all this, Post-Keynesian monetary analysis can appear ‘fractured’, characterized by two hostile and seemingly irreconcilable theories of the endogenous money supply process. The argument in this chapter is that this impression is false – that there can be, and to an extent already is, agreement that the horizontal credit supply curve is not a special case, and that the existence of an indeterminate dynamic credit supply schedule provides a general framework capable of accommodating both horizontalist and structuralist arguments. As will become clear, these arguments rest on the distinction between logical and historical time and, in particular, the claim that any construct (including, for example, a credit supply schedule) that is akin to a determinate long run equilibrium relationship is anathema to the methodological foundations of Post- Keynesian economics. The remainder of this chapter is organized as follows. The next section demonstrates the generality of the horizontal credit supply schedule. In the third section, the idea of a dynamic credit supply schedule is introduced. The 3 Chapter Title necessary indeterminacy of this construct is shown to provide a framework of analysis capable of accommodating both horizontalist and structuralist arguments regarding the credit supply process. It is also shown that there is already de facto recognition of this in the literature. The final section offers some conclusions. THE GENERALITY OF THE HORIZONTAL CREDIT SUPPLY CURVE At first glance, the identification of horizontalism as a special case may seem obvious. Since any non-zero interest-elasticity of the credit supply schedule is consistent with the endogeneity of money (because it implies that an increase in the demand for credit will cause an increase in the quantity of credit supplied, thus increasing the aggregate money supply), it follows that any non-vertical credit supply schedule depicts an endogenous money environment. And since it is possible to draw many upward sloping credit supply schedules but only one horizontal schedule, the latter inevitably appears to be a special case. But this reasoning is based on a ‘geometric illusion’. More precisely, it commits the basic Classical error identified by Joan Robinson of confusing movement through space with movement through time. The horizontal credit supply curve should be interpreted initially as an instantaneous rather than an inter-temporal construct. This instantaneous credit supply curve describes conditions at a point in time, not movement through historical time. More concretely, the horizontal instantaneous credit supply schedule simply shows that given the central bank’s current discount rate (δ) and the mark-up (θ) currently established by commercial banks, on the basis of which the current value of the commercial interest rate (r) is established as: r = (1 + θ) δ (2) the actual quantity of credit supplied in the current period (and hence the size of the money supply) is indeterminate. The quantity of credit supplied is, of course, determined by the demand for credit (from credit-worthy borrowers) at the current interest rate, which commercial banks cannot but accommodate, having already formulated and quoted the terms of trade as established in (2). In this sense, a horizontal credit supply curve is nothing less than the only plausible representation of the credit supply conditions that prevail at any given instant, given the assumptions that we have made above about the production and pricing of credit by commercial banks – all of which are consistent with the generic Post-Keynesian conception of Book Title 4 endogenous money, as described in the previous section. Far from being a special case, then, the horizontal credit supply curve is thus revealed as very much the general case. Note, moreover, that the duration of the ‘instant’ to which this general case, horizontal instantaneous credit supply schedule applies will depend on the institutional configuration of the banking system. In particular, it will depend crucially on the length of the market period for which commercial banks conventionally keep their mark ups fixed, together with the frequency with which the central bank conventionally makes decisions as to whether or not to change the discount rate. In short, the ‘instant’ is defined by the conventional pricing procedures of the central bank and commercial banks, and is thus likely to be a discrete interval of calendar time. It is important to bear this in mind throughout the discussion in the following section, which makes the distinction between instantaneous and dynamic credit supply schedules with the latter purporting to describe credit supply conditions over time. Clearly, in light of what has been said above, ‘over time’ must here refer to events over intervals of calendar time longer than the institutionally defined ‘instant’ discussed above.
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