Interest rate exogeneity: Theory, evidence and policy issues for the U.S. economy

The idea of an exogenous money supply —controlled entirely through central bank interventions— was a fundamental tenet of monetarism and New Classical economics. Post Keynesians have developed an extensive literature arguing that the money supply is in fact endogenous —that market forces combine with central banks in establishing the money supply. But Post Keynesians disagree on a related question: to what extent are interest rates set exogenously by central banks? This paper presents evidence regarding the movement of interest rates in U.S. financial markets relative to the Federal Reserve-controlled Federal Funds rate. Concluding that market interest rates are primarily set through market forces, that is, are largely endogenous. This is the instability of deregulated financial markets, which leads market participants to make wide swings in their risk assessments over time. It follows that effective regulatory policies to stabilize markets and control interest rates directly will increase the degree of interest rate exogeneity.