The Theory of Endogenous Money: Mechanics and Implications for Macroeconomic Analysis and Monetary Policy

This paper presents the Post Keynesian theory of endogenous money supply and shows how it is fundamentally different from the conventional money supply theory. Money is at the center of macroeconomics, which makes understanding the money supply central for macroeconomic theory. The conventional approach relies on the money multiplier and bank lending is invisible. Post Keynesian theory discards the money multiplier and focuses on bank lending which drives money creation. The paper emphasizes the structuralist version of Post Keynesian theory as it retains Keynes’ liquidity preference theory of long term interest rates and also recognizes banks are subject to financial constraints that limit their lending activities. The paper also shows how to derive the LM schedule in an endogenous money economy. Lastly, the paper shows how an endogenous money perspective has important implications for monetary policy which should be constructed in terms of short-term interest rate policy, long-term interest rate policy and credit market policy.