Teaching Macroeconomics When the Endogeneity of Money is Taken Seriously

Abstract

The purpose of this chapter is to consider the implications of treating money as endogenously created within the banking system rather than the more traditional use of the assumption of exogenous money (that is money created by an external agency such as the central bank) for the teaching of macroeconomic analysis and how that teaching could be approached. The underlying view on which this chapter is based is that macroeconomic analysis based on endogenous money has to be substantially different from one based on exogenous money, and the differences are much more fundamental than merely shifting from an assumption that the stock of money is given to the one that the (policy) rate of interest is given (cf. Romer, 2000). With the endogenous money approach, in contrast with the exogenous approach, ‘money matters’ for the level of economic activity and for the evolution of the economy over time². Expenditure can only take place if it is backed by purchasing power, and expenditure has to be financed through the possession of money, which can come from provision of loans by the banks. The level and composition of expenditure clearly determines what is produced and sold. The decisions on loans by banks influence the number of investment plans that can be financed and which can take place, and thereby the size and character of the capital stock, and hence on the development of the supply side of the economy.

I am grateful to Giuseppe Fontana and Mark Setterfield for their comments and guidance on an earlier draft, and to Philip Arestis and Peter Howells for extensive discussions on the subject matter of this chapter.