Moore (1979) The endogenous money stock

Does money supply determine inflation or does inflation determine money supply?

In The endogenous money stock, Basil Moore makes the case that the quantity of money is determined more by bank credit responding to cost and price increases than vice versa. He divides the inflation problem into two questions: (1) what is the relation between monetary growth and inflation? and (2) What is the source of change in the money stock? The data shows clear correlation between money supply and inflation, so the bigger focus is on question 2.

Moore first lays out the monetarist argument:

"The essence of monetarism can be expressed in two central propositions: a) Monetary changes are the dominant cause of changes in nominal income, swamping the temporary and minor influence of fiscal changes. b) There is no long-run, stable trade-off between inflation and unemployment; that is, the natural rate of unemployment hypothesis is valid. Changes in the rate of monetary growth cannot cause the rate of unemployment to diverge permanently from its "natural rate," except under conditions of continuously accelerating inflation."

Monetarists recommend monetary restriction to fight inflation. Their recommendation did not change when the evidence in the early 1970s (sluggish downward response of wage rates to high unemployment) proved their prescription to be painful and ineffective. Tobin has written that "Distinctively monetarist policy recommendations stem less from theoretical or even empirical findings than from distinctive value judgments. The preferences revealed consistently in those recommendations are for minimising the public sector and for paying a high cost in unemployment to stabilise prices."

One of the main sources of doubt about the monetarist argument is the question of causality.

"While the monetarists have made a case for the exogeneity of money in terms of the ability of the central bank ultimately to control the money stock, in their empirical work they unfortunately have confused the issues of causality and exogeneity. The money stock is indeed exogenous in the sense that it is ultimately under the control of the central bank. But, in econometrics, exogeneity is used in another sense: to say that a variable is exogenous is to regard it as independent of the influence of the variable whose value it seeks to explain. ... [However] the Federal Reserve and other central banks characteristically have accommodated the needs of business and the Treasury, and have operated to maintain orderly conditions in the bond markets and stabilize market interest rates."

Moore uses the relationship between prices and wage increases to show that 

"if the monetary authorities do not permit the money stock to accommodate to the rate of increase in money wages, monetary demand will not be sufficient to maintain existing employment output. Financial disorder will result if contractual obligations cannot be met, leading to downward pressure on the growth of real income and an accompanying rise in unemployment ... to the extent the authorities follow an accommodating monetary policy in order to prevent financial instability and enable real income to follow its trend path, the nominal rate of growth in the money stock will be determined by the rate of growth of money wages." 

Sort of reiterating that point, with a view of the whole economy:

"In modern economies, production costs are normally incurred and paid prior to the receipt of sales revenue. These costs represent a working-capital investment to the firm. If current production flow costs duplicate the following period, the proceeds from past sales will exactly finance current working capital costs. When wage increases raise production costs, however, even unchanged production schedules will require more working capital in money terms. Accordingly, firms must increase their borrowing from banks to finance these higher production costs for each level of output. In this manner, increases in money wage rates which exceed productivity increments and so raise unit labor costs will lead to an endogenous increase in the demand for credit, even if the aggregate production flow remains unchanged.

"Whenever the central bank accommodates this increased demand for credit, there will be a high statistical correlation between increases in the money stock and increases in prices, with the former preceding the latter."

Of course, the world is uncertain and not in equilibrium:

"The pervasive uncertainty of the real world means that decision makers seek to hold buffer stocks -- that is, inventories -- as a mechanism for absorbing unforeseen shocks ... The buffer stock par excellence is money. This suggests that individuals do not immediately adjust their money balances to a unique desired equilibrium level, but allow their holdings to fluctuate up or down, until some ceiling or floor limit is reached, before making the adjustment. To the extent that the above analysis is correct, supply-side changes (credit) largely determine short-term monetary growth. If money is supply determined in the short run, it follows that the demand for money is in short-run disequilibrium. Evidence for this is the fact that changes in real money balances [the amount of stuff a given amount of money can buy] are largely independent, and real money balances typically rise initially when the nominal money stock expands sharply. Only over the longer term is the price level determined by restoration of the equilibrium demand for money function.

In summary:

"Economists have mistakenly accepted the high-powered base approach to the determinants of monetary growth. Bank lending is the proximate and predominant source of monetary change. With lagged reserve requirements, once the deposits have been created the central bank has no choice but to make the required reserves available."