Endogenous Money in Foreign Exchange Markets

Abstract

This paper analyses the endogeneity of money creation or destruction when banks and central banks act in foreign exchange markets. From a historical analysis of banking operations it is derived that endogenous money in foreign exchange transactions originated together with banks as depository institutions. Combinations of central bank, banking system or non-banking system sectors interacting in foreign exchange markets are analysed. Modern banking systems when purchasing foreign currency pay with the issuance of newly created deposits. The analysis is performed using a „balance sheet approach to money‟ methodology. Empirical evidence is provided with statistical analysis of the Swedish banking system‟s assets and liabilities, concluding that the Swedish banking system borrows foreign currency and exchanges it for domestic currency resulting in a bank money destruction. An exemplary stock-flow consistent model is presented inhibiting the effects of endogenous money in foreign exchange markets. In conclusion in the short-run foreign currency demand may be met with quantity increases instead of price increases and in the long-run it is relevant for economies on how foreign currency is obtained, by which sectors, and how it is used.