Paper Nathan Rogier and Carlos

8/6/2019 Paper Nathan Rogier and Carlos

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The Transmission Of Monetary Policy in the US: Testing The Credit Channel

And The Role Of Endogenous Money

NATHAN PERRY

Mesa State College

ROGIER KAMERLINGEconomist, M&I Bank, Capital Markets Division

CARLOS SCHNERWALD

Universidade Federal do Rio de Janeiro Brazil

ABSTRACT: This paper discusses and tests the causality for the endogenous money hypothesis

in the United States from 1980 to 2010. The paper employs Granger causality tests in order to

determine the causality of loans to various bank level variables. The results show evidence forthe endogenous money hypothesis. The combination of the results suggests that the demand for

loans is the ultimate driver of bank activity, which is consistent with the endogenous money

hypothesis.

JEL Classification: E5, O4.

Keywords: Monetary Policy, Endogenous Money, Money Multiplier


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Introduction

There are two primary channels by which monetary policy is thought to effect bank

loans: the interest rate channeland the credit channel. The interest rate channel affects loans by

adjusting the price of money to clear excess between supply and demand, and the credit channel,

whereby changes in open market operations affect excess reserves, leading to changes in bank

lending.

Post Keynesian economics supports the notion that the money supply is endogenous.

Endogenous money creation is the idea that money supply is a function of the demand for bank

credit. Within the Post-Keynesian tradition lie two primary strands of thought. The first is the

accomodationist view, which argues that a demand for loans is met with banks borrowing from

the Federal Reserve. The structuralist viewpoint argues that when entities demand loans, banks

supply the loan and create funds by using liability management to respond to loan demand. In

both views, the demand for loans is the ultimate constraint on bank lending, not excess reserves

or deposits. The causality goes from demand for loans to excess reserves, or innovative liability

management techniques, not from deposits/reserves to loans as the conventional literature

dictates.

The Post Keynesian view contrast severely with the exogenous multiplier approach. The

money multiplier approach states that banks buy short-term debt instruments from banks,

increasing excess reserves. Banks lend out their excess reserves, only holding required reserves,

increasing the total number of loans and hence bank and economic activity. The directional

causality goes from a change in open market operations, to a change in excess reserves, to a

change in loans. This money multiplier approach is listed in some version in virtually all


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macroeconomics and money and banking textbooks and is taught as the primary mechanism by

which the Federal Reserve conducts monetary policy. The money multiplier approach works in

the same way for deposits. Savers deposit money into a bank, the bank lends out the deposit

money that is not required reserves, this money makes its way back to the banking system, and

the multiple deposit creation approach continues.

The objective of this paper is to empirically test the endogenous money hypothesis in the

US from 1980 to 2010. Granger causality tests are used to determine which way causality runs.

The results show evidence for endogenous money approach. Ultimately, the authors believe that

the evidence is more in favor of endogenous money because of the role of the demand for loans.

Additionally, we use the granger causality tests along with two other tests taken from Pollin

(1991) to show evidence for either the accomodationist view or the structuralist view of

endogenous money. The paper is organized as follows: section 2 compares the traditional bank

lending approach to the endogenous money approach. The difference between the

accomodationist view and the structuralist view is also covered, as well as the relevant literature.

Section 3 discusses the data and the Granger causality tests, and section 4 details the results.

Literature Review

Within the Post Keynesian literature, two primary theories exist to explain the role of the

money supply in regards to bank loans: the accomodationist and the structuralist. The

accomodationist view argues that the Federal Reserve sets a target interest rate, and supplies

reserves as needed for banks to meet loan demand. The interest rate in this scenario is perfectly

elastic and is dictated by the central banks manipulation of the proportion of non-borrowed

reserves to total reserves. This then determines the banks demand for borrowed reserves. Much


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of this literature owes to Kaldor (1982) and Moore (1988), and leaves little room for liability

management, since the Federal Reserve fully accommodates loan demand.

From the accomodationist perspective, the Federal Reserve has complete control over

interest rates through its setting of the discount rate and open market operations. Other rates then

move in accordance with these short term rates (Kaldor 1982). Lavoie (2008) points out that

several central banks and banking systems in general work the way the accomodationists

theorize, including the bank of Canada. The Bank of Canada requires no reserves and banks may

borrow freely from the Bank of Canada, making the Canadian system a fully accommodative

system. Pollin (1991) points out three important tenants of accommodative endogeneity. The first

tenant is the proportionality in the relative movements of loans and reserves, if the

proportionality of loans to reserves stays the same, then there is strong evidence for full

accomodationism from the Central Bank. The second is the substitutability between borrowed

and non-borrowed reserves, implies that borrowed and non-borrowed reserves are equal in a

banks eyes, even accounting for frown costs. The third tenant is that the Federal Reserve sets

short term interest rate.

The structuralist view, see Pollin (1991) and Palley (1994), argue that the central bank

only partially accommodates a banks demand for reserves. Instead, in order for banks to meet

loan demand, they must pursue liability management to raise funds instead of relying solely on

borrowed reserves. Pollin (1991) explains that structural endogeneity does not accept the view

that discount window borrowing is a close substitute for non-borrowed reserves, even adjusting

for frown costs. In the structuralist framework, banks do not fully accommodate bank demand

for reserves, which forces banks to find other sources of liabilities. Since the end of regulation Q

and since the innovative creation of different liability management tools in the 1960s and 1970s


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made liability management the primary tool by which banks respond to loan demand. Since it is

generally frowned upon by financial markets to seek discount loans, these loans are sought only

as a last resort. Banks use existing deposits and liability management in response to loan

demand, and then seek Federal Funds loans from other banks to meet reserve requirements, and

take out discount loans only in emergencies. The Federal Reserve accommodates through open

market operations and some discount loans but is not fully accommodating. Pollin (1991) notes

that liability management creates a lend first, find reserves later practice for banks, and allows

banks to avoid strict reserve requirement restrictions that an increase in deposits would bring.1

Liability management practices allow banks to expand the total value of loans offered despite theCentral Bank potentially manipulating the total level of reserves.

In an endogenous money system where the Federal Reserve in some form (whether the

full accomodationist view or the structuralist view) supply reserves in response to both the

issuance of credit and the demand for money. In the Post Keynesian system the ultimate

constraint is not the supply of credit, which is the traditional approach, but the credit worthiness

of banks as well as the expectation of the overall macroeconomy. The microuncertainty

constraint refers to the credit worthiness of banks and the willingness of the lender to supply

loans based on the probability of default. Borrowers must either show they can produce more

income to cover the debt payments or have enough collateral to ensure low default risk (Lavoie

1996). The macrouncertainty is the uncertainty that all firms face that is related to the business

cycle (Rochon 2006). Microuncertainty exists regardless of the business cycle, as firms are still

capable of failing even if effective demand is relatively high. Part of the macrouncertainty is the

1Pollinpg.375


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volatility of interest rates. A rise in interest rates can easily put a poorly hedged bank or business

from the tipping point of breaking even to large losses.

As Lavoie (1984), Rochon (2006), and Moore (1988) point out, when macrouncertainty

becomes too great, banks increase the credit requirements for loans. As the business cycle

weakens banks become strict with loans in order to ensure repayment of debts. As the business

cycle improves, banks, following their animal spirits, lower loan requirements, becoming less

strict with lending and lowing the markup costs of loans. Keynes is more succinct in explaining

that during a boom the popular estimation of the magnitude of lenders risk is apt to become

unusually and imprudently low (Keynes, 1936, pg. 145). Rochon (2006) explains a credit

crunch quite succinctly, A credit crunch, in a post Keynesian world, is therefore explained not

by a decrease in central bank reserves and a corresponding leftward shift in the supply of bank

credit. This implies a scarcity of available funds, and hence the need to ration supply in light of

greater demand. For post-Keynesians, credit is constrained not because demand is greater than

supply, but because banks become very pessimistic and they choose not to lend to certain

borrowers. (Rochon, 2006, pg. 182). Minsky (1982) also covers the credit crunch

phenomenon and argues that a credit crunch can occur when money markets do not generate the

necessary reserve supply, at which point loans will be called in and assets will be sold to create

the necessary reserves. At this point liability management ceases to be an unlimited source of

funds based on the demand for borrowing. At this point, the source of funds in liability

management becomes constrained endogenously.

There are two ways in which researchers approach proving causality. The first is using

Granger-Sims causality tests, the second is to determine causality with a VAR. Both Vera (2001)

and Shanmugam (2003) use Granger causality tests to determine causality for Spain and


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Malaysia respectively. Each find reasonable evidence that causality runs from loans to other

variables, primarily different measures of money supply including M2 and the monetary base.

Carpenter and Demiralp (2010) employ 2 primary procedures to test the money multiplier

approach. The first is using bank level data and Granger causality tests. The authors test the

standard multiplier approach against the liability management approach (endogenous money

approach). The authors show no evidence for the money multiplier approach, and strong

evidence for the liability management approach. The second procedure employed is a VAR using

a methodology similar to Bernanke and Blinder (1992). The findings again showed little

evidence for the traditional money multiplier approach post 1990. The empirical section will build upon Vera (2001), Shanmugam (2003), Pollin (1991), Moore (1988), and Carpenter and

Demiralp (2010) in an attempt to prove causality for endogenous money vs. exogenous money,

and within the endogenous approach the structuralist vs. accomodationist debate.

Data/Methodology

Data was collected from the Federal Reserve, is in monthly format, and stretches from

1980 to October of 2010.2 The year of 1980 was chosen as the start year for two reasons: 1)

Regulation Q was passed which changed the nature of liability management and hence the

reliance of banks on reserves and deposits; 2) Bank liability data only goes back to 1978. Each

variable was tested for stationarity using the Augmented Dickey Fuller (ADF) test. When unit

roots were found, the first difference of the variable was used. All variables are in log form. The

optimal lag length for the ADF test was chosen using the Elliott-Rothenberg-Stock (1996)

method. The optimal lag length for the granger causality tests was chosen based on the AIC

criterion. The variable definitions are as follow:

2Resultswerealsofoundusingweeklydataandweresimilar.


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LRR = log of required reserves

LM2=log of M2

LL = log of loans

LBL= log of bank liabilitiesLD= log of deposits

LER = log of excess reserves

LCD= log of CD

Table 1

Unit Root tests

Variable t-value/(# of lags by AIC) Critical Values

1% 5% 10%

LRR -1.944 (13) -3.986 -3.422 -3.130LM2 -.0285 (16) -3.986 -3.422 -3.130LL -2.027 (8) -3.986 -3.426 -3.130LBL -0.696 (12) -3.986 -3.426 -3.130LD -2.328 (5) -3.985 -3.425 -3.130LCD -1.427 (4) -3.985 -3.425 -3.130LER -0.597 (10) -3.985 -3.425 -3.130* indicates that the null hypothesis !!: ! = 0 can be rejected at the 5% significance level, but cannot be rejected atthe 1% level** indicates that the null hypothesis !!: ! = 0 is rejected at the 1% significance levelAugmented Dickey Fuller (ADF) Tests (lags selected using AIC criterion) (1980 to 2010)

Table 2

Unit Root tests

Variable t-value/(# of lags by AIC) Critical Values

1% 5% 10%

DLRR -4.106 (12)** -3.986 -3.422 -3.130DLM2 -4.036 (8)** -3.451 -2.876 -2.570DLL -3.325 (12)* -3.451 -2.876 -2.570

DLBL -3.978 (11)** -3.451 -2.876 -2.570DLD -4.636 (5)** -3.451 -2.876 -2.570DLCD -6.310 (4) ** -3.451 -2.876 -2.570DLER -3.916 (10) ** -3.451 -2.876 -2.570* indicates that the null hypothesis !!: ! = 0 can be rejected at the 5% significance level, but cannot be rejected atthe 1% level** indicates that the null hypothesis !!: ! = 0 is rejected at the 1% significance levelAugmented Dickey Fuller (ADF) Tests (lags selected using AIC criterion) (1980 to 2010)


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Table 3

Testable Hypothesis

DLD => DLLDLL=>DLD

DLER=>DLLDLL=>DLERDLM2=>DLLDLL=>DLM2DLBL=>DLLDLL=>DLBL

The granger causality tests are listed in Table 4. The goal is to test the causality between

bank level variables and loans. If loans are shown to Granger cause reserves, M2, liability

management, or deposits, then there is evidence for the endogenous money hypothesis. In an

endogenous money world, credit creation creates deposits, which means there should be a strongcausality from loans to deposits.

Table 4

Granger causality test

*** indicates that the null hypothesis cannot be reject at the 1% level** indicates that the null hypothesis can be rejected at the 1% significance level but cannot be rejected at the 5%level* indicates that the null hypothesis can be rejected at the 5% significance level but cannot be rejected at the 10%level

6 lags 12 lags 18 lags

DLD => DLL 26.004(.000)***

22.650(.000)***

48.461(.000)***

DLER=>DLL 21.500(.001)***

39.297(.000)***

56.715(.000)***

DLM2=>DLL 10.745(.097)*

43.915(.000)***

51.473(.000)***

DLBL=>DLL 12.973(.043)**

26.503(.009)***

31.021(.029)**

DLL=>DLER 10.486(.106)

20.016(.067)*

29.352(.044)**

DLL=>DLM2 24.715(.000)***

15.870(.197)

31.484(.025)**

DLL=>DLBL 29.601(.000)***

36.869(.000)***

46.614(.000)***

DLL=>DLD 20.037(.003)***

22.650(.031)**

37.987(.004)***


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The results of the Granger causality tests indicate evidence for the endogenous money

approach. Using the AIC criterion, 6 lags was determined to be the optimal lag length, so this

section will focus on the results of the causality tests with 6 lags. The money multiplier approach

shows that 3 of the 4 causalities tested are significant at the 95% level. The only causality that is

not significant at the 95% level is from M2 to bank loans ( DLM2=>DLL). The results show that

an increase in deposits Granger causes and increase in bank loans.

Three of the four endogenous money causalities were significant at the 95% level, with

the 4th causality barely missing the 90% significance level. A change in loans does not Granger-

cause excess reserves, but does cause a change in M2, a change in liabilities, and a change indeposits, which are all strong indicators of an endogenous money system.

It is possible that dual causality exists, and it is possible to find evidence for this when

utilizing both Granger causality tests and vector auto regressions. The endogenous money

literature shows strong evidence for the causality going from loans to money creation, but that

does not necessarily mean that all money creation is endogenous. The Federal Reserves

manipulation of excess reserves can affect loans depending on the demand for money. The

endogenous money literature is very clear about the role of the demand for loans as the constraint

to both endogenous money creation and the money multiplier approach. For instance, had the

Federal Reserve conducted expansionary monetary policy in 2005 during the peak of the housing

bubble, it is likely that this increase in reserves would have gone directly to loans. At this point

in the business cycle, the demand for loans was high enough that changes in excess reserves had

a direct impact on loans. Note however, that even though the causality in this theoretical

approach goes from excess reserves to loans, the demand for loans was still endogenous to the

business cycle. During the financial crisis and afterwords in QE2, the Federal Reserve has


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pumped billions of dollars into banking reserves through open market operations, discount loans,

and government programs. This did not create excessive lending because the demand for loans

was too low, probably due to poor expectations of future profitability and poor present

profitability.

The results provide evidence for the structuralist view over the accomodationist view.

There is more evidence for the structuralist point of view because it is very clear that loans

granger cause liability management practices, whereas the causality from loans to reserves does

not meet the 90% threshold. One central tenant of accomodationism is that the Federal Reserve

fully accommodates bank lending with reserves. It follows that if there is an increase in loans,there should be an increase in reserves. The results of the granger causality tests show little

evidence for an increase in loans causing an increase in reserves. Loans to deposits is highly

significant, but the causality of loans to deposits is proof for both the accomodationist view and

the structuralist view, as under both scenarios an increase in loans should increase deposits.

The authors repeated Pollins (1991) test of stationarity for the loan to reserves ratio to

provide more evidence for this finding. Pollins results of non-stationarity for the loan to reserves

ratio hold using both an augmented Dickey-Fuller test, using a visual analysis (Figure 1), and

repeating the mean/variance results listed in Pollins paper.


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Figure 1 Loan/Reserve Ratio

Source: Bloomberg

Granger causality tests were used for similar data from 1959 to 1979 for comparison

purposes. Before the many of the innovations in liability management during the 1970s and

1980s, it is suspected that the banking system would show more evidence for the conventional

money multiplier approach. As was the case with the 1980 to 2010 data, unit roots were tested

for using the Augmented Dickey Fuller test. Each variable showed a unit root except for loans.

The logs of all variables were taken. Liability side data, as well as deposits in monthly format

are not available before 1973 so they are omitted. The optimal lag length for the dickey fuller

test was selected using the Elliot-Rothenberg-Stock (1996) approach. The optimal lag length for

the granger causality test was chosen using the AIC criterion.

The primary causality of interest is the causality from excess reserves to loans, and vice

versa. This particular time period shows that changes in excess reserves granger cause total

0

20

40

60

80

100

120140

TimePeriod

1960-03

1961-06

1962-09

1963-12

1965-03

1966-06

1967-09

1968-12

1970-03

1971-06

1972-09

1973-12

1975-03

1976-06

1977-09

1978-12

1980-03

1981-06

1982-09

1983-12

1985-03

1986-06

1987-09

1988-12

1990-03

1991-06

1992-09

1993-12

1995-03

1996-06

1997-09

1998-12

2000-03

2001-06

2002-09

2003-12

2005-03

2006-06

2007-09

2008-12

2010-03

Loans/Reserves


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loans. There is some evidence (at the 90% level) that loans granger cause excess reserves, but

not as strong as the later time periods.

Conclusion

This paper has two primary conclusions: first is that there is evidence for endogenous

money when tested against the traditional money multiplier approach. The results were

consistent with both the accomodationist and the structuralist approaches. Granger causality ran

predominantly from bank lending to the various money multipliers. The hypothesis that liability

management practices were a significant device for the accommodation of loan demand in the

US was confirmed.

Second, since there is evidence for endogenous money it is clear that there is much more

evidence for the structuralist view. The role of liability management is well established, and due

to technological improvements and financial innovations it has become a normal part of banking.

The results show that the Federal Reserve is not fully accommodating, or at least that banks find

liability management more convenient than Federal Reserve borrowing, either due to actual costs

or frown costs.

Bibliography:

Pollin, Robert. Two Theories of Money Supply Endogeneity: Some Empirical Evidence.Journal of Post Keynesian Economics, Vol. 13, No. 3 (Spring, 1991), pp. 366-396.

Keynes, John Maynard. The General Theory of Employment, Interest and Money. New York:Harcourt, Brace & World, 1936.

Kaldor, Nicholas. The Scourge of Monetarism. New York: Oxford University Press, 1982.

Kaldor, Nicholas. How Monetarism Failed. Challenge, May/June 1985, 28(2), 4-13.


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Minsky, Hyman P. Can It Happen Again? Essays on Instability and Finance. Armonk, NY:M.E. Sharpe, 1982.

Moore, Basil J. Horizontalists and Verticalists: The Macroeconomics of Credit Money. New

York: Cambridge University Press, 1988.

Palley, T. Competing Views of the Money Supply Process: Theory and Evidence.Metroeconomica, 1994, 45 (1), 67-88.

Palley, T. Accommodationism Versus Structuralism: Time for an Accommodation. Journalof Post Keynesian Economics, Summer 1996a, 18 (4), 585-594.

Very, Alfonso Palacio. The Endogenous Money hypothesis: Some evidence from Spain (1987-1998). Journal of Post Keynesian Economics, spring 2001, Vol 23, No. 3.

Demiralp, Selva, and Seth B Carpenter. Money, reserves, and the Transmission of MonetaryPolicy: Does the Money Multiplier Exist? Federal Reserve Board Discussion series, 2010-41.

Shanmugam, Bala, Mahendhiran, Nair, and Ong Wee Li. The Endogenous Money Hypothesis:Empirical Evidence from Malaysia (1985-2000). Journal of Post Keynesian Economics, Vol.25, No. 4 (Summer, 2003), pp. 599-611.

Elliot, Graham, Tothenberg, Thomas J., and James H. Stock. Efficient Tests for anAutoregressive Unit Root. Econometrica, Vol 64, No. 4 (Jul., 1996), pp. 813-836.

Bernanke, Ben, and Alan Blinder. 1992. The Federal Funds Rate and the Channels ofMonetary Transmission. American Economic Review, 82 (4): 901-921.

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Paper Nathan Rogier and Carlos