Theory of Supply – Competing Views of the Money Supply
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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 1960s. However, the model explicitly focuses on the money
supply implications of the banking systems 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