Endogenous Money in the Age of Financial Liberalization

Abstract

The paper reports that no statistically significant empirical relationship can be shown between total bank credit and the US broad money supply in the period after 1995. It argues that the growing prevalence of non-bank deposits in the form of mutual money market funds and asset securitization are the main culprits for this result. Prior to financial liberalization, the connection between total bank credit and broad money supply was simple enough: new bank deposits were created when banks made loans and were extinguished when loans were paid back. In banks' consolidated balance sheet, total deposits made up total liabilities and were basically equal to the broad money supply. However, in the age of financial liberalization not all deposits bank loans created returned as deposits, whether in banks or non-banks, as deposits could be swapped for non-deposit liabilities without a corresponding draw down on the asset side. Moreover, loans could be extinguished in banks' balance sheets through asset securitization.