Modern Monetary Theory

Modern Monetary Theory

from Asad Zaman

This continues from the previous post on Post-Keynesian Response. A large number of contributions from different areas need to be integrated to build an economics for the 21st Century. For an acknowledgement of the failure of 20th Century Macro from one of its architects, see Romer’s Trouble With Macro. This post explains Modern Monetary Theory briefly.

Since the time of Keynes, major changes have taken place in the global financial system. Against wishes of Keynes, Bretton-Woods created a dollar centered system based on notional exchangeability of dollars for gold. The Nixon Shock in 1971 removed the gold backing from dollars, leading to the modern world of floating exchange rates. Dramatic changes in the monetary exchange systems and financial institution play no role in orthodox modern macroeconomics, since money and finance are not (supposedly) part of the real economy. Taking the nature of modern money and the financial institutions into serious considerations leads to many important insights which lie at the core of MMT. Three major innovations lie at the foundations of this theory. These are summarized below:

Endogenous Money: MMT reflects an institutional perspective on the creation of money. When Central Banks set discount rates, they lose control of the quantity of money, which must be issued in amounts required to equilibrate the demand/supply of money at the policy rate. Private creation of money depends on bank-lending, which in turn depends on the investment climate. Bank credit depends on expectations, sound collaterals, and also a keeping-up-with-the-Joneses effect – if everyone is lending, banks cannot afford to stay out. Theories of endogenous money underlie Minsky’s Financial Fragility Hypothesis, which suggests that the money creation process is inherently destabilizing because private credit is expanded at the top of the business cycle and contracted at the bottom, exactly the opposite of what is required for good economic management.

Functional Finance: read more