Endogenous Money, Principles, Erik Dean

Endogenous Money

Level: Undergraduate, principles

Author: Erik Dean

License: CC-BY

Author’s notes: This content was developed for an introductory macroeconomics course. It explains the heterodox idea that banks can create money by making loans.

Introduction

In this lecture, you'll begin to understand money and banking from a heterodox perspective.  Central to this is the idea that money is not fundamentally a commodity-thing like a gold coin.  Instead, money is a credit-debt relationship--an IOU, if you will.  Once we begin to look at money in this way, our understanding of the roles that money, banks, interest, and so on play in modern capitalist economies will change dramatically.  The next section, 'Modern Money & Banking' will cover how we can understanding banking from the perspective that sees money as an IOU.  But before we get to all that, it will be useful to think a bit about how we look at interest, because, as you'll see this is a central issue in the topics of money and banking.

Modern Money & Banking

The pen is mightier than the sword, as they say.  As you'll see in the next video, many heterodox economists reject the notion that money is a scarce commodity, and that banks store that money and lend some of it out.  Instead, from the heterodox perspective, banks act as the clearing houses and originators of credit-debt relationships--that is, money as IOUs.  

A Simple(ish) Example

It's not necessarily easy to wrap one's head around the idea that banks can just create money 'from thin air', so to speak.  As individuals, we're culturally conditioned to see money as a physical thing to be acquired so that we can live.  It might be detrimental to that intuition to think that money is really just a set of social relationships, only existing in numbers on a bank ledger or spreadsheet.  Just the same, this really is what money is--from a heterodox perspective, at least--and understanding that is crucial for understanding how actual capitalist investment, production, employment, and so on take place.  To help you see how money is created by banks, the following video will give a relatively simple example.

Although the example in the video above involved a number of unrealistic simplifying assumptions, the essence of the process does reflect how most money is actually created--not just in modern times, but historically as well.  There is one important component, however, that we haven't covered: the role of the government in issuing currency.  We'll return to that topic at the end of the term.  

Liquidity in a Complex Economy

Now that you've got a decent understanding of what banks do from both the orthodox and the heterodox perspectives, we can start to look at how banking in general fits into the broader capitalist system.  The video below will do this, and in the process start to develop a (post) Keynesian theory of interest rates. 

It's worth emphasizing why interest rates are so important to macroeconomics.  Interest represents, among other things, the cost of borrowing.  If, as Keynes argued, output, income, and employment are driven by demand (spending), then to the extent that spending is financed by borrowing, interest rates constitute the cost of spending.  Hence, if interest rates rise, it will be more expensive to borrow, which will depress spending, and therefore the economy.  

When economists think about high interest rates depressing spending, we usually have in mind business spending on investment; but, of course, households borrow to spend as well--on houses, cars, education, and so on.  Because of this, we should expect that interest rates play an important role in many parts of our economy.