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The endogenous money theory is that funds will be available in whatever amount is needed to meet demand for credit. It is essentially the belief that bank reserves, such as those supported by the central bank, will be replenished in one area when cash supplies are depleted in another. For example, a loan may reduce a bank’s reserves, but when the customer makes the loan payments, the levels rise again. The endogenous money theory is expressed in several different branches, each of which describes different characteristics of the flow of money. Although the different branches of endogenous money theory hold the same general belief, they are not necessarily compatible with each other.
Some of the different types of endogenous money theory include central bank endogeneity, fiscal endogeneity and currency multiplier, and portfolio endogeneity. Central bank endogeneity is the theory that the monetary authority will provide the funds to help banks meet the demand for credit. Fiscal endogeneity is the theory that the economy, and therefore the banks, will be their own source of funds through the natural cycle of the deficit and the debts and credits that drive it. The currency multiplier and portfolio endogeneity are based on the belief that properly balancing investments in the general market will ensure adequate supply of credit.
According to the endogenous money theory, the supply of funds is determined by the demand for bank credit. For example, if there is low demand, reserves are typically high and the monetary authority will withhold funds. When the demand for credit increases, part of the reserves will be distributed to banks so that the increase in activity will boost the economy.
In some cases, the central bank will not use reserves to accommodate a demand for credit, but often banks will have their own resources to manage this type of situation. For this reason, the endogenous money theory also depends on the asset and liability practices of banks. Mismanagement of these elements can affect the bank’s ability to meet demand, whether or not the central bank provides funds.
At the heart of the endogenous money theory is the belief that money is primarily a tool and that the economy is, in essence, a system of exchange. The government’s monetary authority is supposed to increase or decrease the flow of funds from the central bank to ensure that this system can thrive. This is primarily accomplished by controlling cash flow so that prices are neither too high nor too low for the exchange of goods and services to take place at a sufficient level of activity.