The bulk of all money transactions today involve the transfer of bank deposits. Depository institutions, which we normally call banks, are at the very center of our monetary system. Thus a basic knowledge of the banking system is essential to an understanding of how money works.

Bank Deposits and Reserves

The monetary base is created by the Fed when it buys securities for its own portfolio. Bank deposits themselves are not base money, rather they are claims on base money. A bank must hold reserves of base money in order to meet its depositors’ cash withdrawals and to cover the checks written against their accounts. Reserves comprise a bank’s vault cash and what it holds on deposit at the Fed, known as Fed funds. The Fed requires banks to maintain reserves of at least 10% of their demand deposits, averaged over successive 14-day periods.

The Movement of Bank Reserves

When a depositor writes a check against his account, his bank must surrender that amount in reserves to the payee’s bank for the check to clear. Reserves are constantly moving from one bank to another as checks are written and cleared. At the end of the day, some banks will be short of reserves and others long. Banks redistribute reserves among themselves by trading in the Fed funds market. Those long on reserves will normally lend to those short. The annualized interest rate on interbank loans is known as the Fed funds rate, and varies with supply and demand.

The reserve requirement applies only to the bank’s demand deposits, not its term or savings deposits. Thus when a bank depositor converts funds in a demand deposit into a term or savings deposit, he frees up the reserves that were held against the demand deposit. The bank can then use those reserves in several ways. For example, it can hold them to back further lending, buy interest-earning Treasury securities, or lend them to other banks in the Fed funds market.

Controlling the Fed Funds Rate

The supply of reserves changes whenever base money enters or leaves the banking system. This occurs when the Fed buys or sells securities or when the public deposits or withdraws cash from banks. The demand for reserves changes whenever total demand deposits change, which occurs when banks increase or decrease aggregate lending. The Fed controls the Fed funds rate by adjusting the supply of reserves to meet the demand at its target interest rate. It does so by adding or draining reserves through its open market operations.

The Fed funds rate effectively sets the upper limit on the cost of reserves to banks, and thus determines the interest rates that banks must charge the public for loans. Bank interest rates influence the demand for loans, and thereby the net amount of bank lending. That in turn determines the liquidity of the private sector, which is important in terms of aggregate demand and inflationary pressures. The selection and control of the Fed funds rate is the key monetary policy instrument of the Fed.

The Effects of Government Spending

The Fed acts as a depository for the Treasury as well as member banks. All government spending is paid out of the Treasury’s account at the Fed. Whenever the government spends, the Fed debits the Treasury’s account and credits the Fed account of the payee’s bank. The Treasury replenishes its Fed account with transfers from its commercial bank accounts where it deposits the receipts from taxes, and the sale of its securities.

In order to minimize variations in aggregate banking system reserves, the Treasury maintains a nearly constant balance in its Fed account. In effect, Treasury payments are simply transfers from its commercial bank accounts to the bank accounts of the public. Funds move in the reverse direction when the public pays taxes or buys securities from the Treasury. The Treasury must maintain a positive balance in its commercial bank accounts to avoid having to borrow directly from the Fed. However it has no need for, and does not accumulate, balances in excess of its near-term payment obligations.

On average, government spending does not affect the aggregate bank deposits of the private sector. The Treasury sells or redeems securities as required to balance its inflows against outflows. However short-term variations occur because receipts cannot be synchronized with spending. Banking system reserves remain essentially unaffected by government spending because the Treasury transfers funds from its commercial bank accounts to replace the funds spent out of its Fed account.

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This overview provides a short introduction to the U.S. monetary system. Details can be found in later articles. The terms in italics are links to the Glossary and back.

1. The banking system, including the Federal Reserve, is the source of all dollar-denominated money. The Fed creates the monetary base, also known as Fed money, comprising notes and coins and deposits at the Fed. Banks expand the money supply by issuing loans, and thereby create credit money.

2. The Fed influences the amount of bank lending through its selection and control of the Fed funds rate, the benchmark for all short term interest rates. However it does not directly control the amount of credit money created by commercial banks which are private profit-seeking enterprises.

3. The amount of money created is a function of the demand for bank credit at the going lending rate. Banks normally lend to any borrower who is found capable of paying the interest and returning the principal on a date-certain. Bank-issued credit money is the principal part of the money supply.

4. A bank’s lending is ultimately limited by the amount of its equity, based on the capital ratio requirement set by the Fed. Banks must also meet a reserve ratio requirement, but in fact the Fed normally provides the required reserves in order to maintain control of the interbank lending rate, i.e. the Fed funds rate.

5. The Fed controls the Fed funds rate through its open market operations, buying or selling securities short term for its own portfolio. This adds or drains banking system reserves as needed to balance supply and demand at its chosen target rate. Banks temporarily short of reserves may borrow directly from the Fed’s discount window.

6. To support the increasing demand for currency and bank credit money, the Fed purchases Treasury securities directly from the public. This is referred to as monetizing the debt, which increases the monetary base in direct proportion to the increase in the value of Treasury securities held by the Fed.

7. Government spending via the Treasury does not increase the money supply. It spends funds recycled from the public through taxes and/or bond sales. The government could print money to cover its spending, but that hasn’t happened since the Accord of 1951.

8. The Treasury does not accumulate money balances in excess of its near term obligations. Thus the reciprocal flow of funds between the Treasury and the public is essentially balanced at all times, whether the budget is balanced or not.

9. The national debt owed to the public by the Treasury can be maintained indefinitely by simply rolling over T-bonds as they mature. When the budget is balanced, current tax revenues fully cover interest paid on the debt.

10. Paying down the national debt does not free up money for either the public or the government. Every dollar of debt paid off merely transfers dollars from taxpayers to bond owners, and dissolves assets used as a savings vehicle by the public.

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Where does all the money go when stock prices plummet?

This question mistakes the monetary value of stocks for money itself. Stock prices simply reflect the current market value of the shares. At the end of the day, buyers own more shares and less money, while sellers own fewer shares and more money. Their aggregate financial wealth may be higher or lower, but the total amount of money they own remains unchanged in these transactions.

The government causes inflation when it prints too much money.

Money is literally printed by the government only to meet the demand for portable currency, i.e. Federal Reserve notes. The notes are issued to banks in exchange for deposits the banks hold at the Fed. The public acquires the notes in exchange for their own deposits at banks. The amount of currency issued is no more and no less than the public desires to hold as wallet money or rainy day money. It has no bearing on inflation.

Price inflation is mainly caused by too much money chasing too few goods.

The general price level is correlated with the money supply, but correlation should not be confused with causation. Prices are seldom driven by the money supply. More commonly, the money supply reacts to changes in the general price level which can be affected in many ways unrelated to the money supply. Money growth depends on the demand for bank loans and the willingness of banks to lend. The Fed can influence the demand through its control of the interest rate. Only if it sets the interest rate too low for an extended period would the money supply grow fast enough to put upward pressure on prices.

Banks lend the money of their depositors.

When banks issue loans, they create new deposits without disturbing existing deposits. That is precisely what causes the money supply to grow, and is what distinguishes bank lending from all other types of lending. A non-bank intermediary like a finance company lends what it has on deposit at a bank. It cannot create new deposits as a bank is able to do.

When a bank receives a new deposit, it can issue a new loan for ten times that amount.

The bank can loan that much only if its reserves at the Fed, including the amount received with the new deposit, is sufficient to cover a check written by the borrower for the full amount of the loan. It will lose that much in reserves to the payee bank when the check clears.

The money multiplier explains how much money banks can create.

The money multiplier has no predictive power. It is simply an after-the-fact observation of the ratio between aggregate demand deposits and banking system reserves. A bank’s lending is constrained by its capital adequacy, not its reserves.

Bank reserves ensure that funds will be available for withdrawals by depositors.

Minimum reserve requirements on banks were once viewed as a protection for depositors. Many countries now impose no reserve requirement on their banks. Banks must hold sufficient reserves to cover withdrawals by depositors. But a solvent bank that is temporarily short of reserves can borrow them from the central bank or in the money market. Conversely a bank can hold ample reserves and still be insolvent. Protection for depositors against default is provided by deposit insurance, not by the reserves of the banks.

The Fed controls the size of the money supply.
A bank in the U.S. must hold reserves of base money in proportion to the amount of its demand deposit liabilities. However the amount a bank may lend is limited by its own capital, not its reserves. In order to maintain control of the Fed funds rate, i.e. interbank lending rate, the Fed must provide whatever reserves are required by the banking system as a whole. In fact if the Fed withheld reserves, it could imperil the liquidity of one or more banks. Thus for all practical purposes, the Fed cannot even control the amount of base money it issues.

Government deficit spending increases the money supply.

Deficit spending increases the net financial wealth of the private sector in the form of Treasury securities, not money. Every dollar the Treasury spends is money previously created by the Fed. The Treasury simply recycles the money it acquires from taxes and the sale of securities. In the aggregate, the public pays for Treasury securities out of the funds acquired from the deficit spending itself.

Government borrowing drains loanable funds needed within the private sector.

The government does not borrow to accumulate funds in the Treasury. It borrows only to cover its deficit spending, and thus does not affect the size of the private sector money supply on average. While government borrowing could temporarily reduce the supply of loanable funds within the private sector, that effect is short-lived and typically negligible.

The national debt is a burden on future generations.

This is based on the false premise that the national debt must be paid off by the private sector some day. In reality, the government itself pays to redeem its debt securities as they mature, using funds obtained by selling new securities to the public. This “rolling over” of the national debt can be continued indefinitely, since the government can pay whatever interest rate the market demands for its securities.

Interest paid on the debt reduces the funds available for other government spending.

There is no basic constraint on government spending in its own currency. Interest payments and the revenues that support them are part of the balanced reciprocal flow of funds between the Treasury and the private sector. Their only effect is a redistribution of financial assets, which of course is true of all government spending.

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According to conventional wisdom, the Federal government spends taxpayers’ money. In reality it spends its own base money and recaptures it with taxes and the sale of bonds. In the long run it must spend at least as much as it recaptures. Otherwise the economy would be drained of the base money it needs to operate. Base money underlies the money supply of the private sector, which consists mainly of bank deposits, i.e. bank money. In order to influence the amount of bank money issued, the government must control the cost of acquiring base money which banks need to cover their depositors’ transactions.

The Importance of Government Spending

The Treasury can be viewed as a money pump that continuously recycles base money with the private sector. The outflow due to government spending is matched on average by the inflow from taxes and bond sales. Government spending engages the private sector in work which would otherwise not be performed under private initiative. An example is the building of the interstate highway system.

The outflow also includes various subsidies and transfer payments that may not directly engage work, but are important in redistributing purchasing power. That in turn results in income to firms and their employees. Note that government spending of any kind redistributes income. It is beneficial to the extent that it contributes to a robust economy, with a decent standard of living for all citizens.

Compensating for Treasury Spending

The Treasury pays the government’s bills out of its account at the Fed. Those payments inject new deposits and reserves of base money into the banking system. Since that would increase the money supply and interfere with the Fed’s ability to implement monetary policy, it compensates in the following ways:

(1) When tax revenues do not fully recapture government spending, the Treasury recaptures the excess with the net sale of its securities. Conversely if the Treasury receives more tax revenues than needed to recapture its spending, it net redeems its securities. Government spending therefore has no direct effect on the aggregate money supply, on average.

(2) As it spends, the Treasury replenishes its Fed account with equal transfers from its commercial bank accounts, where it deposits its receipts from taxes and bond sales. This removes the reserves of base money created by its spending. Aggregate reserves of the banking system therefore remain unchanged, on average.

The Balanced Reciprocal Flow of Funds

In effect, the Treasury simply recycles base money previously created by the Fed. Its outflows and inflows move bank deposits and reserves around the banking system without changing the total on average. The Treasury has no use for balances in its own bank accounts in excess of what it needs to cover its near-term payments. It normally holds about one week’s worth of government spending, which currently averages about $60 billion.

The long term increase in the public’s money supply is due to (1) net borrowing from banks and (2) the increasing demand for currency. As the money supply increases, the Fed must inject reserves into the banking system to balance supply against demand at its target Fed Funds rate, its primary monetary policy tool. It does so by purchasing Treasury securities held by the public.

Why the Treasury Can Always Sell its Securities

As long as the Federal government enforces tax collection, its base money will be in demand. Since base money earns no interest, when the private sector has more than it desires to hold in the aggregate its only interest-earning alternative is Treasury securities. The Treasury can pay whatever interest rate the market demands, so there will always be willing buyers of its securities.

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Credit is the lifeblood of the economy. The amount and quality of credit market debt is a measure of the size and vitality of a nation’s economy. All such debt rests like an inverted pyramid on a small foundation of money known as the monetary base. The implicit assumption is that credit market debt is convertible at maturity into base money.

The monetary base is the definitive money of a nation, meaning the State has no obligation to convert it on demand into some other form of money. The State defines the unit of account in base money, makes it legal tender for all debts, public and private, and requires that payments to the State be in base money. In the following, we deal mainly with base money of the U.S.

A Brief History

During the era of gold as money, gold coins comprised the monetary base. The production of money was basically in the hands of the private sector. The State minted it or printed the certificates used in trade to represent it, while private enterprise mined the ore and reaped the benefits of doing so. The total amount produced was not under State control, but the relative scarcity of gold acted to maintain its exchange value at an acceptable level most of the time. The State had to acquire a share of the base money by levying taxes and fees on the public.

Today the monetary base is created in the form of inconvertible notes issued by the Federal Reserve, and bank credits at the Fed which can be exchanged for notes on demand. When the U.S. ended the use of gold for domestic currency in 1933, any constraint on the issue of base money was effectively removed. The State now has unlimited spending power in base money, and necessarily holds a monopoly on its issue.

Bank Credit and Base Money

A private enterprise with sufficient financial capital may obtain a charter that permits it to accept deposits of base money from the public, and to issue loans in the form of credit convertible to base money on demand. These depositories, commonly known as banks, must hold sufficient base money, called reserves, for that purpose.

When one deposits a check or cash in his account at a bank, he receives credit in exchange which we will refer to as bank money. We expect banks to redeem those credits for cash on demand.

Most of the money in use today exists as credits issued by private banks. However when one pays by drawing on his bank account, if the check is deposited in another bank, the payer’s bank must transfer an equal amount of reserves to the payee’s bank. Thus base money is the foundation of the bank money system.

Base Money as Credit

In reality, base money itself is a form of credit. In the same way a contract can be viewed as a document or the agreement it represents, money can be viewed as a token or the credit it represents. And since credit for the holder is debt for the issuer, money can also be viewed as a token representing third party debt. In the case of base money, the third party is the Fed.

All base money originates with the Fed. For the most part, it is issued in exchange for securities the public bought from the Treasury with base money previously acquired from the Fed. This circular system of credit is difficult for some to understand, especially for those who think of money only in terms of the token itself rather than the credit represented by the token.

If base money is simply a form of credit backed by Treasury securities, which are another form of credit, then what assures its viability as money, and what is the real basis of its value?

The Viability of Base Money

A token qualifies as money when it is widely accepted as a medium of exchange. To be accepted in that way, it must be seen as a store of value, even though its value may decrease before its planned re-use. Notes and coins are convenient tokens because they are easy to use and reasonably durable. Bank deposits, which are claims on base money, can easily be transferred by wire to or from any bank. It remains to explain then why those tokens have value. Their status as legal tender in the discharge of debts is not sufficient because it says nothing about their value in ordinary use.

The viability of base money ultimately depends on the government enforcing tax collection, and acting to maintain a modest rate of price inflation. Base money acquires value because that is what the private sector must deliver in paying Federal taxes. Those who have no tax liabilities readily accept payment in base money because it is needed by so many others. In essence, base money is a tax credit.

The Fed’s base money liabilities are closely matched by its assets in the form of Treasury securities that it previously bought from the public. But what prevents the real value of those Treasury securities from being diluted by continued deficit spending? As will be explained, the purchasing power of base money has very little to do with the amount of deficit spending. However it does depend in the long run on the cost to banks of acquiring base money, which the Fed itself controls.

Fed Operations

Since base money is a monopoly of the State, the Fed must issue enough to avoid a shortage of what the public must use to pay its taxes. In practical terms, that means it must provide whatever reserves the banking system needs to ensure the liquidity of the payment system.

When the Fed needs to increase aggregate reserves, it buys Treasury securities from the public and credits the sellers’ banks with additional deposits at the Fed. Conversely the Fed sells Treasury securities to the public from its own portfolio when it needs to decrease aggregate bank reserves. Bank reserves are only a small part of the monetary base, but they play a key role because they are the grease that enables the bank credit system to function.

These transactions by the Fed are designed to balance supply and demand for bank reserves at the Fed’s target interest rate on overnight loans between banks, otherwise known as the Fed funds rate. The Fed funds rate is the benchmark for all short-term interest rates. It has a significant influence on the amount of bank money issued, and thus the liquidity of the private sector. In controlling the Fed funds rate, the Fed necessarily relinquishes control of the amount of base money it issues. The private sector itself determines the net amount issued.

Treasury Operations

The Treasury spends out of its account at the Fed. It continuously replenishes that account with transfers from its accounts in commercial banks where it deposits its receipts from taxes and the sale of bonds. These so-called Treasury Tax and Loan accounts in commercial banks are backed by deposits at the Fed, which are reserves of the banking system.

Treasury operations simply recycle base money previously issued by the Fed. It approximately balances its receipts from taxes and the sale of bonds against its spending in order to avoid large variations in the demand deposits of the private sector which could significantly affect liquidity. It targets a fixed balance in its account at the Fed in order to minimize variations in the aggregate reserves of the banking system. The Fed compensates for the variations by adding or draining reserves on a short-term basis through its open market operations.

If the private sector as a whole holds more base money than it needs, it will normally use the excess to purchase interest-earning Treasury securities, since base money earns no interest. Thus the Treasury will always be able to recapture its deficit spending through the sale of securities, since it can pay whatever interest the market demands.

Managing Inflationary Expectations

The interest rate the Treasury must pay to borrow is a market rate which is influenced by Fed policy. The short-term rate closely tracks the Fed funds rate due to arbitrage. Longer-term rates include a premium over the Fed funds rate which varies with inflationary expectations. Although many diverse factors affect those expectations, the Fed itself has considerable influence through its monetary policy decisions.

It is therefore up to the Fed to keep inflationary expectations within acceptable limits. By doing that well, it protects the purchasing power of base money, and ensures that interest rates on long term borrowing will not become so burdensome as to prevent economic growth.

Contrary to conventional wisdom, the historical record shows no significant correlation between the amount of deficit spending and the inflation rate or interest rates. Most central banks now target a small positive inflation rate to provide a margin against a deflation trap. Deflation hurts aggregate demand by creating a money-hoarding psychology which is difficult to overcome, and may result in a prolonged recession. Under the gold-based system, the State’s ability to counter inflationary and deflationary pressures was very limited.

In Summary

Base money is simply another form of credit. The Fed issues base money in exchange for credits issued by the Treasury which the public previously bought with base money. This circular system of credit works as long as the State broadly enforces tax collection. Price inflation varies in the short run for a number of reasons not directly under the control of the State. In the long run, Fed policy in setting the cost to banks of acquiring base money is the key to controlling the average inflation rate.

B2B Solutions Tags: another form of credit, Bank Credit, Base Money, Base Money as Credit, cash, exchange for credits, Fed Operations, Managing Inflationary Expectations, Money, Money School, The Monetary Base, The Viability of Base Money, Treasury Operations, Understanding Money

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Money does not exist in a pure barter system. Trades are negotiated by the participants as a fair exchange of goods and services. If someone agrees to receive equivalent value later in exchange for his goods, he has accepted an IOU. An IOU is a credit for the seller and a debt for the buyer. If the IOU becomes negotiable, meaning others will accept it in exchange for goods and services, the IOU is money. In essence, money is credit that is widely accepted as a medium of exchange.

The Basic Properties of Money

An IOU will be accepted in exchange for goods and services only if it is seen as a store of value. However it does not have to store value indefinitely to qualify as money. It is money if it retains value long enough to be generally accepted as a medium of exchange. Money is always a store of value, but a store of value is not always money. For example, a bond is a store of value, but bonds are seldom accepted as a medium of exchange, and therefore are not money.

Most of the money we use is denominated in the unit of account established by the government. That enables us to measure the value of a good or service against another, based on what each sells for in the market. How many quarts of milk are equivalent in value to a barber shop haircut can only be determined in the market place.

IOUs as Money

Money is the credit side of a balance sheet relation. Every dollar of credit is matched by an equal amount of debt. A bank loan creates a credit for the borrower in the form of a negotiable IOU (the deposit) and a matching debt (the obligation to repay the loan). For the bank, it creates an often illiquid asset (the loan contract) and an equal liability (the negotiable IOU).

The term money is sometimes used in reference to high quality debt instruments nearing maturity. However such near-money is seldom acceptable as a medium of exchange. Besides being inconvenient to the seller, the monetary value of near-money is not really known until sold in the marketplace. The more restrictive definition of money will be adopted here.

Fed Funds and Bank Money

When the Fed purchases a financial asset from the public, it credits the seller’s bank with a deposit at the Fed, known as Fed funds. Banks can exchange Fed funds for Federal Reserve notes, and vice versa, on demand. In either form, these Fed IOUs are the most negotiable in the economy. This is because the private sector must surrender Fed funds in paying Federal taxes. Conversely the government pays in Fed funds when it spends.

Individuals usually pay taxes with bank money, i.e. a check against a bank deposit. However the bank must cover the check with its own Fed funds. It cannot issue an IOU to cover the check. The Fed accepts bank money at par with its own IOUs. Thus bank deposits are nearly as negotiable in the private sector as Fed funds. Private party IOUs may be legally binding, but they are of uncertain monetary value and seldom negotiable. They are simply private debt rather than money.

Non-Bank Money

Money market mutual funds offer accounts similar to checking accounts at banks. They are actually shares in the ownership of short-term debt. When one pays with a draft on a money market fund, he is in fact selling shares in exchange for bank money that the fund must deliver. That means the fund must have sufficient bank money on hand, or acquire it through borrowing or sale of its own assets.

Although money market mutual funds are not insured or guaranteed to trade at par with Fed money, their acceptance is now so widespread that they have become de facto money. Thus non-bank financial institutions (NBFIs) can create money by selling an interest in short-term paper, and providing checking facilities against that paper.

Banks as Intermediaries

Like other intermediaries, banks borrow to lend at a profit. However banks are a special kind of intermediary because of their role as depositories. When a bank lends, it creates a new deposit to fund the loan and thus expands the money supply. It may issue loans only up to a prescribed multiple of its capital, and it must hold reserves of base money sufficient to cover net daily withdrawals of its depositors.

Reserves refer to a bank’s vault cash and its Fed funds. Under present rules, a bank must hold 10% in reserves against its demand deposits, averaged over successive two-week periods. Averaging allows a bank to run below its required reserves on any given day. Interbank lending serves to redistribute reserves lost to other banks due to ordinary checking activities.

A bank can acquire Fed funds by borrowing in the money market, but it cannot increase its capital (assets minus liabilities) through borrowing. Banks with sufficient capital sometimes create new deposits without adequate reserves, and count on borrowing to meet the reserve requirement. That may leave the banking system short of reserves, and thus apply upward pressure on the interest rate in the Fed funds market. In order to defend its target interest rate, the Fed will supply the required reserves on its own initiative. Thus a net increase in credit issued by the banking system normally brings forth new base money.

Non-Banks as Intermediaries

Banks were once the main source of credit. Today NBFIs such as mutual funds, pension funds, finance companies, and insurance companies issue far more credit in total than do banks. Indeed, deposits created by banks now comprise less than 20% of the total credit market debt.

NBFIs are ordinary intermediaries that lend by transferring their own bank money to the borrowers. For example, NBFI B borrows $1 million from investor A at X%, and lends $1 million to entrepreneur C at Y%. In effect, $1 million in A’s bank account is transferred to C’s bank account. No new money is created, but the total credit market debt increases by $2 million. B expects to earn (Y-X)% on $1 million. C expects to profit from its loan, pay regular interest, and pay off its debt to B when it comes due. B will then have funds to pay off its debt to A.

What matters in this scenario is cash flow. Intermediaries typically borrow short to lend long, taking advantage of the normally upward sloping term structure of the yield curve (yield versus maturity). Such an intermediary must be able to roll over short-term debt on a continuing basis at favorable interest rates. If its credit standing is suspect, it may not be able it to borrow at all.

Cash flow also depends on factors over which the intermediary has no control. Suppose the Fed raised short-term rates sharply. Not only might B be in trouble due to the higher cost of rolling over its short-term debt, but C might also find its income reduced. If C were unable to service its debt, B might also fail, in which case A could lose a good part of its investment.

Systemic Risks

The Fed has virtually no control over the total amount of credit market debt. However the real danger to the financial system is not in how much credit is created. It is in the cascading of debt relations in which a single default can result in a system-wide reaction.

NBFIs are important players in a modern entrepreneurial economy, but they are not regulated as to their capital ratios or the type of assets they may hold. There is a constant danger of an over-leveraged NBFI having to default on a large debt. While the Fed or other financial institutions would likely come to the rescue, it is by no means certain that widespread havoc could be avoided under the rules that now exist.

B2B Solutions Tags: Banks as Intermediaries, cash, Fed Funds and Bank Money, Money, Non-Bank Money, Non-Banks as Intermediaries. Money as Credit, The Basic Properties of Money, Understanding Money

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What is meant by the money supply? The term itself implies that a certain amount of money exists at any given time, even though the quantity may be unknown. In truth there can be no meaningful measure of the quantity because it is continually varying as a function of demand.

The Fed has its own arbitrary measures of the money supply which it once used to help guide its monetary policy decisions. It defines money as the total of cash in circulation and deposit liabilities of banks and thrifts. At one time it set targets for the growth of the money supply. Now it largely ignores its own measures because it has found little correlation between them and its major policy objectives – limiting inflation and unemployment.

Monetary Aggregates

The Fed has defined three monetary aggregates M1, M2, and M3. The narrowest definition, M1, includes the transaction deposits of banks and cash in circulation. M2 adds savings accounts, small time deposits at banks, and retail money market funds. M3 adds large time deposits, repurchase agreements, Eurodollars, and institutional money market funds. In March 2006 the Fed discontinued tracking M3 because it does not convey information about economic activity that is not already embodied in M2.

Note that the Fed’s definition of the money supply includes only what the non-bank sector holds. Thus the reserves of banks, i.e. vault cash and deposits at the Fed, though a part of the monetary base, are not included in the monetary aggregates. That means when a bank spends for itself, it increases the money supply. When it receives payments from the public such as interest on loans, the money supply decreases.

Bank Lines of Credit as a Money Equivalent

An important shortcoming of the Fed’s definition is that it ignores lines of credit which can be exercised at the discretion of the borrower. Firms often hold substantial lines of credit from their banks, which they can use on short notice. Likewise consumers hold lines of credit in their credit card accounts that are just as useful for purchases as checking accounts or the currency in their wallets. Lines of credit increase liquidity, which is ultimately what counts in terms of enhancing aggregate demand.

When someone uses a credit card in a purchase, he automatically expands the money supply. The seller receives a new deposit in his account, which increases the total of demand deposits in the banking system — until the buyer pays off the loan. The result is that consumers who roll over their credit card loans rather than paying them off have increased the money supply on their own initiative by hundreds of billions of dollars. In effect, the money supply is substantially larger and less measurable than the Fed’s definition.

The Quantity Theory of Money

Economists regularly use the term money supply without defining it. A notable example is the equation of exchange in the quantity theory of money.

MV = PT

This relates the money supply, M, and the velocity of money, V, to the average price level, P, and the total number of transactions, T, in a given time period. The equation is simply an identity, meaning it is true by definition. Yet it is often used to “prove” that the average price level increases with the quantity of money. An identity says nothing about causal relations. The only thing we know is the product MV, which equals the national income, PT, which itself is only roughly measurable. The quantity of money, M, remains undefined and unknowable.

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