Introduction
During the ancient times of economies, precious metals were used to make currency by imprinting the government stamp. The value of the currency was determined by the value of the precious metal used to mint the currency. It was also a time when the financial credibility of the Government was not a matter of concern. Thus a country’s value and economic power was measured by the amount of reserves of precious metals.
The introduction of the paper currency was done during the period of industrial revolution. These paper currencies were supported by “promise to pay” notes. Later on when gold became the nation’s real back up aid for currency “Gold standard” was introduced. And there after nations strived to maintain its gold reserves to support their “promises to pay” notes. Thereafter a nation’s economic strength was determined by their amount of gold holdings.
Later on Central Banks were introduced by nations to ascertain monetary power. Central banks actively participated in the money supply and creation of money demand. This in turn helped in controlling the credit creation and economic stability of a nation. The modern monetary policy rarely uses Gold, which in effect is completely detached from the Gold standard. From the time Federal Reserve took control of money and credit, economic consistency is attained by Central bank; by diverting the extent of money in flow, the cost and accessibility of credit, and the combination of a nation’s obligations.
To execute monetary policy, three tools are being used by Central banks They are Open Market Operations, where direct buying and selling of govt bonds in the open market by the central bank, b. Reserve ratio, which is a percentage that must be reserved with Central bank as per the banking regulation act by commercial banks and other depository institutions for maintaining proper money supply and credit (Monetary Policy).
Main body
Money supply theory studies the availability of money with in the economy. On the other hand interest rate is the value for this money ultimately, it is the value paid for the payment of monetary obligations. These two are related in the sense that as the supply of money increases the interest rate decreases (Money Supply Theory).
Endogenous money is the money generated with in the nation, though it is issued by the central bank and can be managed by the banking systems. On the other hand exogenous money is that source of currency generated from outside the nation and that comes to the nation for meeting the requirements of the society. Endogenous money ensures effectiveness with socio-economic integrity (Exogenous and Endogenous Money).
Federal Reserve has the right to execute the monetary policy of a nation. By making frequent changes in the bank reserve, it regulates the flow of money. The traditional form of creating bank deposits depended on the bank reserve-multiplier relation. Based on the changes in the monetary base, and treasury deposits, variations of monthly changes in money are effected. Withholding this fact, money stock is considered as an exogenous variable. Though there is a constant relation between dynamic base and money stock, that to the money stock and aggregate money income, the relation is opposite to the traditional view.
Both money stock and base are in fact endogenous. The facts supporting to the view that money stock is endogenous are as follows;
- Moore opines that the Federal Reserve itself pursues a money market strategy. Central banks persists that money stock creation is an effect of relations among households, Business Corporation, financial institutions, treasury and the Federal Reserve. There is an argument regarding the view of Central bank to decide changes in the money stock, although these critics have appropriate reasons to indicate that finances from stock would stimulate growth which will affect undesirable range of interest rate variation, which in turn would weaken the financial markets. If the reserve growth were controlled, then the private institutions would have to suffer the short term fluctuations of the interest rates. Moreover in the absence of the function of the lender of last resort it is not sure whether the liquidity of financial assets could be steadily secured by holding cash inventories by private agents. Moreover there is a need for an elastic currency to counter balance the weekly, monthly and seasonal crisis ensuing from the interest rate fluctuation and financial crises. This was considered as a serious factor in the Federal Reserve System. If the central banks cannot decide in advance, the changes of monetary aggregate in short run then the determination of the long run activity is mere aggregation of short runs.
- The second supporting factor is based on the bank reserve and the bank deposit.As per the study performed by Feige and McGee, the money stock was exogenous with reserves, before and after the implementation of reserve accounting. In comparison, causality from money to reserve held in both the periods.
- The third support for the endogeneity is contributed from the modern microtheoritic model of the banking concerns. The modern microtheoritic model analyzes a bank as, a two- input, two-output firm; inputs being retail and wholesale deposits and outputs being loans and wholesale lending. The retail deposits and loans are controlled through banking systems and therefore banks are observed as price determiners. On the other hand wholesale deposits and loans are securities, at the same time a part of this is marketed as CD’s, Commercial bills, and banker’s acceptance. Thus, both loans and deposits are observed as demand setters.
- The fourth support towards endogeneity is based on the level with which the modification in the base can be explained statistically with the adjustment in the economic variables, especially monetary wages. According to Moore money wages are most important descriptive variable with extreme positive co-efficient.
The task of monetary adjustment to high money wages occurs through the credit markets. Therefore the attempt of Central bank to manage the rate of increase of monetary aggregates centers on their capacity to manage the rate of growth of bank lending. Once the deposits are created, the Central banks should ensure the required reserves to clear it during the maturity date, else the banks though hard they mix-up the funds, but in aggregate will not able to meet the required reserve. Changes in the bank lending have been the immediate source of annual changes in the money stock over past years.
The fact underlying this is, the banks set the key rate and then try to meet the loan demand. In case the ensuing demand for credit go beyond the banks existing retail and wholesale supply of funds, they will be forced to raise the key rate in advance. In the lack of credit control, the authorities’ capacity to manage the growth of bank credit is done through their ability to influence the short term interest rates. The past study suggests that the capacity of monetary authorities to control the bank credit is limited.
The Central bank emerges to let the money stock to hold to increase in the demand for bank credit. When ever money wages are increasing, it will be hard for the Federal Reserve to limit the rate of monetary growth. The money stock is not acceptable as an exogenous variable because the cash base is under the control of monetary authorities. According to historical view the money stock fluctuates endogenously and the sole factor appears to be the performance of money wages (Moore, B.J. 1983).
Reference
Monetary Policy. Web.
Money Supply Theory. Web.
Exogenous and Endogenous Money. Web.
Moore, B.J. 1983. Unpacking the post Keynesian Black box: bank lending and the money supply. Journal of post Keynesian economics. Vol.V. No.4.