Theory of Supply - Competing Views of the Money Supply

Competing Views of the Money Supply

Process: Theory and Evidence

Thomas I. Palley

Dept. of Economics

New School for Social Research

New York, NY 10003

Revised July 1993 I Introduction.

Within orthodox monetary macroeconomics the determination of the money supply is widely

regarded as unproblematic. Recently, Post Keynesian economists have sought to re-open this issue,

arguing for a re-focusing of attention away from the money multiplier toward the role of bank

lending in this process. The current paper presents three competing models of the money supply

process which illuminate some of the issues in this debate. The first model, labelled the "pure

portfolio approach", corresponds to the orthodox description of the money supply process. The

second model, labelled "the pure loan demand approach", corresponds to the Post Keynesian

"accommodationist" view of endogenous money. The third model, labelled the "mixed portfolioloan demand approach", corresponds to the Post Keynesian "structuralist" view of endogenous

money (see Pollin, 1991a).

This third model is very much in the spirit of the earlier "New View" developed by Gurley and

Shaw (1960), and Tobin (1969) in the 1960's. However, the model explicitly focuses on the money

supply implications of the banking system's response to expansionary shifts of loan demand. The

earlier New View theorists emphasized asset substitutabilities, and focused on changes in asset

prices. This was consistent with their interest in the monetary transmission mechanism, but they

took the money supply to be exogenous. Post Keynesians focus on the implications of asset

substitutabilities for the money supply, and the capacity of the banking system to underwrite

economic activity.

The critical difference between the "pure loan demand" and "mixed portfolio-loan demand"

models concerns the significance ascribed to the private initiatives of banks in accomodating

increases in loan demand. In the pure loan demand model, accomodation depends exclusively on

the stance of the monetary authority, and its willingness to meet the reserve pressures generated by

increased bank lending. However, in the mixed model accomodation depends on both the stance of

the monetary authority, and the private initiatives of banks. These initiatives are independent of the

monetary authority, and are therefore suggestive of the structurally endogenous nature of "finance

capital".

II Three competing models of the money supply.

A. The portfolio choice money multiplier model.

We begin with the orthodox money multiplier model given by

+

(1) Hs = NBR + max [ 0 , BR(i - id) ]

- +

(2) Dd = D(i, y)

- +

(3) Cd = C(i, y)

+ +

(4) Td = T(i, y)

(5) Rd = k1Dd + k2Td

- +

(6) Ed = E(i, id) (7) Hd = Rd + Cd + Ed

(8) Hs = Hd

(9) M = Cd + Dd

where Hs = supply of base

NBR = non-borrowed reserves

BR = borrowed reserves

id = discount rate

Dd = demand for checkable (demand) deposits

Cd = demand for currency

Td = demand for time deposits/bank cerificates of deposit

Rd = required reserves

Ed = demand for excess reserves

Hd = demand for base

i = nominal interest rate

y = nominal income

k1 = required reserve ratio for demand deposits

k2 = required reserve ratio for time deposits

M = M1 money supply

Signs above functional arguments represent signs of partial derivatives. Equation (1) describes the

base supply function, which consists of non-borrowed and borrowed reserves. The level of discount

window borrowing is a positive function of the gap between market interest rates and the discount

rate. Equations (2) and (3) describe the demands for checkable (demand) deposits and currency,

which are both negative functions of the interest rate, and positive functions of income. Equation

(4) describes the demand for time deposits, which is a positive function of the interest rate because

time deposits are interest bearing bank liabilities. Equation (5) is the demand for required reserves,

while equation (6) is the demand for excess reserves. This latter demand is a negative function