1. Two Views of Money
Implications for Fiscal & Monetary
Policy

2. Exogenous vs. Endogenous Money
• Recap:
– Orthodox (exogenous): Money is a commodity
(e.g. gold, silver). It functions as medium of
exchange. Agents not fooled by it; they respond
only to changes in relative values of real goods -
Money is neutral
– Money enters the economy from without –
imagine Fed Chairman Ben Bernanke flying around
in a little helicopter making it rain cash!

3. Exogenous vs. Endogenous Money
• Recap:
– Heterodox (endogenous): money is no object –
not a physical commodity w/ intrinsic value.
Money cannot be neutral – in a monetary
production economy (M – C – M’)
– Keynes: “The possession of actual money lulls our
disquietude; and the premium we require to make
us part with money is a measure of the degree of
our disquietude.” (GT, 1936)

4. Endogenous Money
• Money enters the economy as a result of the
need to finance real economic activity.
– M – C … P … C’ – M’
• Production takes place before sale, which must be
financed either internally or externally. For the
economy as a whole this must be external.
• Thus, loans are required to finance productive activity,
which are then retired once the business enterprise
realizes the increase in value through sales.
• Horizontal Money Creation: Loans -> Deposits

5. Endogenous Money
• Vertical Money Creation Process:
– Government spending: The state’s liabilities are the
money of account; high powered money; show up as
net financial assets
– Gov. Spending creates money; gov. taxation destroys
it.
– If G > T, then deficits accumulate to stocks of
outstanding G liabilities – i.e. the national debt.
– If G < T, then surpluses subtract from the stock of
outstanding G liabilities – i.e. paying down the
national debt.
– More on this later

6. Monetary Policy (Exogenous Story)
r Ms
Equation of Exchange:
MV = PQ
Causality
r* MD
MQ

7. Monetary Policy (Endogenous Story)
The CB cannot control
the money supply r
But, it can control the
interest rate (fed
funds rate).
Equation of Exchange: Ms
r*
MV = PQ
MD
Causality
MQ

8. Fiscal Policy
• In order to get fiscal policy right, we need to understand
how our monetary system works.
• Being wrong can have disastrous consequences on the
economy
– i.e. Volcker Recession of 1981
• Quantity targets failed which caused the interest to rate to rise to
really high levels.
• Erroneously believed the inflation is related to the quantity of money
in circulation
• Caused a recession – probably responsible for starting the decline of
American manufacturing (along with trade policy).
• Exogenous story leads to belief that G can run out of
money. Leads to fears of rising interest rates, unsustainable
debt levels, etc.

9. Endogenous Money & Stock-Flow
Accounting
• In order to formulate good macro policy, we
need to begin with good accounting:
• Flows accumulate to stocks
– Deficits are flows; debts are stocks
– Surpluses are flows; savings are stocks
• One’s financial asset is another’s financial
liability: An IOU (liability) generates a flow of
income to the holder of the IOU (asset)

10. Endogenous Money & Stock-Flow
Accounting
• There are three broad sectors to the economy:
Domestic Private Sector Balance + Domestic Government Balance + Foreign Balance = 0
Over any given period, each sector will either run a surplus, a deficit, or a balanced budget.
And they must sum to zero. This true by extension of the accounting principle that one’s
financial asset is another’s financial liability.