Endogenous and exogenous steering
You occasionally see people debate whether money is “endogenous” or “exogenous”. I will try to explain that debate using the analogy of endogenous and exogenous steering of a car.
Imagine a road network with a series of relatively straight but bumpy highways, and then occasional intersections where people can turn onto an alternative highway, which is also straight but bumpy.
On the straight sections, drivers occasionally nudge the steering wheel to the left or right to keep the car in its lane, after a bump in the road throws it slightly off course. This sort of endogenous steering is done almost without thinking, and involves the driver reacting to the situation in a relatively deterministic fashion.
Endogenous steering is analogous to how the money supply is controlled when a central bank is targeting a short-term interest rate (and doesn’t pay interest on bank reserves.) Prior to 2008, the Fed used to instruct its open market desk to passively adjust the money supply as needed to keep the fed funds rate equal to the target rate for a period of 6 weeks.
In this analogy the fed funds target is like the road, bumps in the road are like shocks to money demand, and adjustments in the money supply are like nudges in the steering wheel that keep the car on track.
Every so often, the driver comes to an intersection. At this point the driver must make a choice; which road is most likely to achieve the driver’s travel goals? Occasionally, they will sense they are not going in the best direction to achieve their destination, and turn the steering to move onto an alternative road. This is exogenous steering, not just a passive response to bumps in the road.
Similarly, every 6 weeks Fed officials would meet to consider whether they are on track to hit their inflation target. If not, they would decide to adjust the money supply in such a way as to move inflation toward their target. If inflation is too high, they’d raise their target interest rate enough to slow money growth enough to bring inflation back on target. Once the new interest rate target was set, money growth again became endogenous—until the next “intersection” was reached. But in a broader context, the interest rate was also endogenous; the target interest rate was set at a position expected to lead to the sort of growth in the money supply that would achieve the inflation target.
So if you ask me whether steering a car is endogenous or exogenous, I’ll answer, “it depends”. If you asked me whether the money supply is endogenous or exogenous, I’ll answer, “it depends”. If you ask me whether interest rates are endogenous or exogenous, I’ll answer, “it depends”. If you see people debating whether a policy variable is endogenous or exogenous without this sort of context, move on and read something else.