Empirical Evidence For The Endogeneity Of The Money Supply In China

One of the principal debates about monetary economics which has always been debated by economists is whether money supply is endogenous or exogenous. The Monetarism of the 1950s made the exogenous money supply theory becoming mainstream, and also the monetary policy of controlling money supply. Then in 1980s, economies preferred other frames, as the financial innovation developed more and more rapidly. The orthodox monetary theory posits that the money supply is determined by the central bank exogenously. On this basis, China adopted the monetary policy framework which influences the money supply. Nevertheless, over the past decades, the economics environment and the transmission of monetary policy have changed. In recent decades, China’s trade surplus kept booming, and there was been a sharp rise in the foreign exchange reserve, causing increasing pressure on the appreciation of Yuan. The accumulation of foreign exchange reserves greatly affected the money base and money supply, and the transmission is Double surplus of balance of payments→Increasing reserves of foreign currency→Funds outstanding for foreign exchange increase→Money supply increased. The central bank’s money supply is actually "adaptive", it launches money in order to accommodate the demand for money in the economy, so the endogency of China’s money supply is becoming stronger and stronger. Under this background, the monetary policy framework which manages the money supply as the main tool is no longer effective, the massive expansion of the money supply could not provide growth in economy which is identical with the phenomena of "Missing Money" Therefore, changing the monetary policy framework was put forward. Some scholars contend a new monetary policy framework. The most different is a shift from quantity to price, so that the monetary policy could effective if the money supply is determined endogenously by the economic system itself.These introduce two questions about the money supply of China:The first one is that whether the money supply determined exogenously or endogenously? And this question introduces the next question:What kind of monetary policy framework should be adopted if the money supply is determined endogenously? This paper try to find solutions that is applicable to the two questions. This paper demonstrates that contrary to orthodox monetary theory that the money supply is exogenously controlled, the money supply is determined endogenously. Based on the premise that money supply equals the money multiplier times the money base, so the study of endogenous money could be start with two aspects:the money multiplier and the money base. Since the instability of the former, this paper analyses the money base to demonstrate endogenous money supply. This paper, based on the balance sheet of the central bank, demonstrates that the fluctuations in foreign exchange reserve affect the money base, and then the money supply, but not vice versa. This paper also analyses the sources of the money base--foreign exchange reserve, net domestic credit and bond issue. The VAR model that this paper runs on China’s data from 2002 to 2014 suggests that changes in the money base depend on foreign exchange reserve strongly. It is a strong empirical support for the endogenous money hypothesis. These findings suggest that most economists need to revise their theories about monetary policy and it is ineffective that the monetary authority affects the economics by controlling the money supply. There should be a shift from regulating quantity to regulating price.