Finance

The central bank practice which emerged in the period following the financial crisis called into question numerous elements of interest rate considerations. In this paper we present a new theoretical framework that dispenses with the concept of real interest altogether, as a vague and unnecessary category both in policy judgements and business decisions. This approach breaks with the traditional theory of economics. Traditional macroeconomics places its argumentation in the context of real analysis, which hinders the understanding of economic processes. Schumpeter and subsequently, Keynes took a stand against this approach and, rebuffing the real approach, turned to monetary analysis as early as a century ago. In the framework of the classical theory of economics, they describe monetary policy as an adjustment to the natural rate of interest. In this article we propose a different approach. Describing the role of fiat money, the endogenous money theory puts the lending activity of commercial banks into the focus of money creation. This concept also put central bank monetary policy in a new framework. According to this approach, central banks assume an exclusive role in determining the interest rates, but the central significance of the interest rate policy weakens. Once we recognise the crucial role of commercial banks in money creation, the role and function of the central bank changes. The central bank no longer controls money creation solely by shaping the interest rate policy, but also by way of the micro and macroprudential regulation of lending. Journal of Economic Literature (JEL) codes: E43, E52, E31

Neoclassical economics uses real analysis and this approach limits its applicability to practical economic problems, including policy applications. Joseph Schumpeter and later John Maynard Keynes himself rejected the approach of real analysis and the notion of money neutrality. They argued that to understand the changes in the economy requires closer reflection of the crucial importance of credit and money. Schumpeter and Keynes promoted monetary analysis as the proper method to analyze the modern economy. This book joins their instructive criticism by raising doubts about the traditional views on interest rate. We deal with a new theory of money and interest rate and I show that Wicksell’s classical concepts of the natural (real equilibrium) rate of interest would not give guidance for contemporary monetary policy practitioners. These terms are unobservable. The natural rate apparently became unstable after the global financial crisis. Such concepts of interest rates are key variables of real analysis, but they are inherently uncertain, and imprecise. There is a growing dissatisfaction with traditional macroeconomic approaches based on the notion of money neutrality in real analysis.
The endogenous theory of money highlighted the importance of money created by commercial bank credit. The central bank’s presumed control over money became questionable. Central banks determine interest rates (short term and nominal) but the quantity of money is determined endogenously. Macroprudencial and liquidity requirement regulations -- which are important factors in influencing commercial bank lending and endogenous money creation -- became the most important instrument the central bank can use to control money.
With respect to money creation, we distinguish between inside and outside money. Inside money is created by the private sector’s need for money helped with bank credit. Outside money is created by the state (not the private sector), but its creation is indirectly influenced by the money demand of the private sector.
We give a brief overview of the historical process of the emergence of money by comparing the main elements of the chartalist and metallist concepts of money. Concerning the current debates about the role of banks in money creation we compare three alternative theories of banking. All three are in conflict with each other in explaining even the basic facts, and yet still they live in peaceful coexistence in textbooks. These three theories treat the role of banks in money creation differently. According to one of the theories, banks simply act as intermedieries in channelling savings to borrowers, and play no part at all in money creation. Another set of theories maintains that individual banks are unable to create money, since they cannot print banknotes, but the banking system as a whole can create money in a manner governed by the central bank by the money multiplier process. According to the third theory banks may create money independently from the central bank endogenously through credit creation. The description of today’s money flows and the interpretation of today’s monetary policy is only possible through the endogenous money theory.
Globally important central banks will increase their interest rate eventually. However, at low interest rates a relatively small increase may lead to significant losses in portfolios with longer duration. Investment funds in their effort to minimize losses by shortening the duration of their portfolios may trigger abrupt changes in capital flows. Increased volatility may undermine financial stability. This type of stability risk is independent of the country’s liquidity situation or weather the banks are well capitalized or profitable. Such systemic risks cannot be managed by macroprudential tools but these tools remain an integral part of monetary policy management.
Keywords: endogenous money, interest rate, money multiplier, monetary policy, Post-Keynesian, macroprudential regulation
JEL: E12, E43, E51, E52, E58, G28