You occasionally see people debate whether money is “endogenous” or “exogenous”. I will try to explain that debate using the analogy of endogenous and exogenous steering of a car.
Imagine a road network with a series of relatively straight but bumpy highways, and then occasional intersections where people can turn onto an alternative highway, which is also straight but bumpy.
On the straight sections, drivers occasionally nudge the steering wheel to the left or right to keep the car in its lane, after a bump in the road throws it slightly off course. This sort of endogenous steering is done almost without thinking, and involves the driver reacting to the situation in a relatively deterministic fashion.
Endogenous steering is analogous to how the money supply is controlled when a central bank is targeting a short-term interest rate (and doesn’t pay interest on bank reserves.) Prior to 2008, the Fed used to instruct its open market desk to passively adjust the money supply as needed to keep the fed funds rate equal to the target rate for a period of 6 weeks.
In this analogy the fed funds target is like the road, bumps in the road are like shocks to money demand, and adjustments in the money supply are like nudges in the steering wheel that keep the car on track.
Every so often, the driver comes to an intersection. At this point the driver must make a choice; which road is most likely to achieve the driver’s travel goals? Occasionally, they will sense they are not going in the best direction to achieve their destination, and turn the steering to move onto an alternative road. This is exogenous steering, not just a passive response to bumps in the road.
Similarly, every 6 weeks Fed officials would meet to consider whether they are on track to hit their inflation target. If not, they would decide to adjust the money supply in such a way as to move inflation toward their target. If inflation is too high, they’d raise their target interest rate enough to slow money growth enough to bring inflation back on target. Once the new interest rate target was set, money growth again became endogenous—until the next “intersection” was reached. But in a broader context, the interest rate was also endogenous; the target interest rate was set at a position expected to lead to the sort of growth in the money supply that would achieve the inflation target.
So if you ask me whether steering a car is endogenous or exogenous, I’ll answer, “it depends”. If you asked me whether the money supply is endogenous or exogenous, I’ll answer, “it depends”. If you ask me whether interest rates are endogenous or exogenous, I’ll answer, “it depends”. If you see people debating whether a policy variable is endogenous or exogenous without this sort of context, move on and read something else.
READER COMMENTS
Thomas Lee Hutcheson
Sep 27 2021 at 10:43pm
Good example, except that many outside observers (and maybe some in the Fed, too) thought that the interest rate WAS the target (not just the instrument) and also except that from 2008-2020 the Fed did not adjust the interest rate (or any other policy instrument) so as to maintain inflation rathe on target, even when both employment AND inflation were below target.
Philo
Sep 28 2021 at 10:07am
Nobody thought “the” interest rate was the target. Everybody knew the target was stable prices and full employment.
Thomas Lee Hutcheson
Sep 28 2021 at 4:55pm
That not the way I heard the commentary. If I’m wrong about the target, great. But it’s still true that the Fed really botched hitting it from 2008-2020.
Henri Hein
Sep 28 2021 at 12:32pm
Thanks for this explanation. That definitely helps in the context of monetary policy. I think I understand pretty well what the terms mean in the statistical sense, but I sometimes get confused when I see economists use them. I assume it’s because I don’t understand the underlying theories well enough.
Sven
Sep 29 2021 at 10:06am
Money is an endogenous variable. Its growth rate is determined at maximum output growth rate with some inflation. Or in your terms nominal GDP. Therefore, money supply changes real economy entirely. This is the key point in terms of endogeneity.
Scott Sumner
Sep 29 2021 at 4:49pm
Did you read the post?
Sven
Sep 30 2021 at 9:26am
After reading again the post, I admit that I did not carefully read it earlier. As far as I understand you basically say that money is endogenous when both the policy tools and targets on their usual track.
So, paying interest to reserves before 2008 are exogenous since it is not a practice on usual course. Or Fed funds rate adjustments after 2008 are exogenous since it is an ineffective policy. The new policy is QE in this case.
As for policy targets, keeping nGDP on optimal level is endogenous (setting aside changing optimal nGDP growth rate). However, high inflation or deflation is exogenous.
It makes sense.
However, I have slightly different approach, in terms of policy tool or in other words by your analogy, the conditions on the road are changing over time. Given this continuous change both short and longer term changes, I consider all of them endogenous. I think what matters is money supply growth. And any policy tool that maintains money supply growth parallel to nGDP growth would be endogenous irrespective to cyclical pattern.
Market Fiscalist
Sep 30 2021 at 12:17pm
Would it a oversimplification to say that whether something is exogenous or endogenous depends upon whether it is an input to a model or something that the model derives?
If you have a model that has the inflation rate as an input and that calculates the money supply (based on the inflation input and some other variables) then inflation is exogenous and the money supply endogenous.
If you have a model that has the money supply as an input and that calculates likely inflation (based on the money supply input and some other variables) then inflation is endogenous and the money supply exogenous.
Joe
Oct 1 2021 at 12:29pm
You’ve been discussing this for a decade. I think this conversation would be a lot easier if some paper was provided with an actual math model that showed us all this. Perhaps Selgin’s free banking math model + central banks would work. Otherwise, its just going in circles because verbal explanations only go so far because the opponent can always just introduce another criticism through the back door.
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