LeoGlossary: Money Supply
The total amount of currency available to the public at a given point in time.
This includes the physical currency that is in circulation (i.e. cash) along with demand deposits and coins. It is what is commonly referred to as legal tender.
Data on the money supply is published by a government entity or the central bank. Many follow the level of the money supply due to the belief it affects price levels of securities, inflation as it related to the price of goods and services, exchange rates, and business cycle.
Money Creation
Under the fractional reserve banking system, the money supply is expanded by the commercial banks through the generation of loans. Money is created when a bank issues out a loan while it is destroyed when the principal is paid back.
Thus it is important to understand the difference between the two different classes of money.
- Commercial Bank - Figures into the M1, M2, and M3 but not the monetary base M0.
- Central Bank Money - This is the monetary base (M0) which includes the physical currency along with obligations of the central bank which includes central bank depository accounts. The physical currency is the banknotes the central bank issues.
Only commercial bank money is in the real economy. The central bank, through monetary policy, can try to make lending more attractive to the banks. It cannot force them to lend nor can it directly insert money into the economy.
Central Bank Influence
The money supply is a topic that is unclear to many people. Central banks do not help to clarify. Their influence is not direct.
Commercial banks are the ones who expand the money supply. Central bank reserves are not legal tender in most countries. When these institutions engage upon quantitative easing (QE), these are instruments placed on the balance sheets of commercial banks. They are only applicable to depository institutions.
The desire is that by increasing the amount of reserves on the balance sheets, banks will increase their lending. Since the central bank cannot inject currency directly into the economy, it has to try to manipulate the banks to lend. The issue is it cannot force the banks to increase their loans.
Inflation
An increase in the money supply is inflation. When there is contraction, deflation is experienced.
Many apply inflation and deflation to price movements. Prices can go up or down based upon a variety of issues. The lockdowns related to COVID-19 caused massive supply chain disruptions.
Milton Friedman most famously pointed out that "Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output." When prices increase as a result of the money supply then inflation is present.
The money supply is tied to loans. For this reason, when the central bank increases it reserves, i.e. "money printing", it has no impact unless banks lend against those reserves. Here is where confusion can arise as the Fed treats cash deposits and the reserves it places on the balance sheets of banks the same. It does not distinguish between the two.
When the Fed Chair, as an example, says the Fed is printing money (or creating it) they are not referring to legal tender. These are bank instruments that do not have broad economy usage. To even have the reserves requires a master account with the Fed.
Another challenge with inflation is the quantity theory of money. Under this, the belief is that an increase in the money supply results in higher prices. It is something that was shown to be inaccurate. This harkens back to Friedman's statement. The problem is that he was writing during a period of stability in terms of the velocity of money. Over the last 30 years, most major countries saw the velocity of money drop significantly.
Eurodollar System
One of the debates regarding the US Dollar is the impact the Eurodollar System has. While this will not affect the money supply since it is not legal tender, the funding mechanism does affect what occurs financially.
The international financial system utilizes assets on a balance sheet in a manner similar to currency. When banks need to settle with each other, they often use these assets, which are denominated in USD, to clear up any obligations.
When there is a shortage of these assets, collateral contraction takes place. This tends to cause an issue with the liquidity of this market.
Many theorize the offshore dollar creation system was responsible, in part for the Great Inflation in the 1970s. The international financial system had figured out a way to generate "money", something they did in an abundant manner.
Whatever the situation then, it is the opposite now. We see Eurodollar contraction as collateral has tightened. This started with the Great Financial Crisis and only spread.
This network relies heavily on derivatives. This is not currency and is in no way tied to the money supply. It is used, at the banking level, as a medium of exchange.
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