Does Money Supply Endogeneity Matter?

Abstract

S RESPONSE to James Dean's (1988) criticism of our work (Whittaker and Theunissen, 1987) has prompted us to add some further remarks. Moore has amply dealt with the central issue of endogeneity (a word which we have preferred to avoid because of the difficulties over its meaning), but there remain points in Dean's paper pertaining to the administration of monetary policy which should be challenged. In our 1987 paper, we describe South African monetary policy as setting the short term rate of interest, via the discount windowan observation which Dean accepts. We then argue that the interest rate must be the instrument of the Central Bank in monetary regimes in which commercial banks offer convertibility of deposits to Central Bank fiat currency. We do not argue, as Dean implies that we do, incorrectly, that the SA Reserve Bank is compelled to use the discount window as its sole domestic policy instrument. In the first place, we are not of the opinion that the discount window can be called an instrument; discount window is merely the term used for one arrangement by which a Central Bank can provide reserves to the banking system. Secondly, our argument is that the Bank must always make reserves available and the Bank therefore cannot avoid choosing the interest cost of reserves. Reserves can indeed be supplied in ways which are notionally different from the discount window as we explicitly point out (Whittaker and Theunissen, 1987; p. 247), but this does not imply that the interest rate ceases to be the Bank's instrument. As Dean observes, the discount window is rarely used in some countries, being supplanted by substitute 'instruments' such as open market operations. In Britain, for instance, a shortage of reserves is generally relieved by the Bank of England inviting discount houses to offer it bills for sale. Although this activity is not called discount window lending, the Bank still sets the rate at which it enters into these deals. Finally, we do not conclude, as Dean says we do, that the SA Reserve Bank cannot 'control' the money supply, even in principle. The Bank 'controls' the money supply to. the extent that the money supply responds to changes in the value of the Bank's interest rate instrument. University of Cape Town 1989 SAJE v57(2) p202