Not all money is equal, as it circulates in different forms from cash bank notes to deposits in the bank which change the way it is valued and used. Here we break down how commercial and federal banks influence the money supply.
Money Supply
The money supply (or money stock) is the total value of money available in an economy at a point of time. There are several ways to define ‘money’, but standard measures usually include currency in circulation and demand deposits (depositors’ easily accessed assets on the books of financial institutions). Each country’s central bank may use its own definition of what constitutes money for its purposes.6
Commercial banks play a role in the process of money creation, especially under the fractional-reserve banking system. In this system, money is created whenever a bank gives out a new loan.
This new money makes up the non-M0 components in the M1-M3 statistics. In short, there are two types of money in a fractional-reserve banking system:
- Central bank money: obligations of a central bank, including currency and central bank depository accounts
- Commercial bank money: obligations of commercial banks, including checking accounts and savings accounts
The different types of money supply
The different types of money are typically classified as ‘Ms’. The ‘Ms’ usually range from M0 (narrowest) to M3 (broadest) but which Ms are actually focused on in policy formulation depend on the country’s central bank. The typical layout for each of the Ms is as follows:
- M0: generally refers to the most liquid forms of money, i.e. currency in circulation. In some countries, such as the United Kingdom, M0 includes bank reserves, so M0 is referred to as the monetary base, or narrow money
- MB: the monetary base or total currency. It generally covers all issued currency and bank reserves held at the central bank. This is the base from which all other forms of money less liquid than currency (like demand deposits, listed below) are created. As mentioned, it is not rare that M0 and MB carry the same meanings
- M1: M0 plus some highly liquid assets such as demand deposits
- M2: M1 plus ‘close substitutes’ for M1. M2 is a broader classification of money than M1 and a key economic indicator used to forecast inflation
- M3: M2 plus large and long-term deposits
The process of money creation essentially creates money supply (M1, M2, M3) from the monetary base (MB). These measures can provide empirical estimates of money multipliers, which are simply ratios of money supply to the monetary base. They empirically reflect how far money spreads in the economy. Also, as we illustrate in the previous chapter, the further down the money hierarchy, the more the money is but also the worse the quality.
Open Market Operations
Central banks can influence money supply and interest rates by open market operations (OMO). Recall that money supply is created from the monetary base through the multiplier effect. As mentioned in the chapter about money creation, the required reserve ratio has a diminishing role in impacting the money supply. Then what is the key monetary tool used by central banks? While it is improbable to precisely control the multiplier effect, central banks almost have full control over aggregate reserves held by banks. And OMO is the most common policy used to manipulate the aggregate reserves and hence the monetary base.
OMO simply means purchases and sales of securities conducted by a central bank in the open markets. When the target is to raise money supply, a central bank purchases securities from the banking sector. The securities involved are usually government bonds like treasury bills. The term ‘open market’ refers to securities dealers competing on the open market based on price, submitting bids or offers to the central bank.
The central bank pays the banking sector by injecting the liquidity into the aggregate reserves deposited at the central bank. This can be understood as converting the securities held by commercial banks into liquid deposits at the central bank. These funds become available to commercial banks for lending, and by the multiplier effect from fractional-reserve banking, loans and bank deposits go up by many times the initial injection of funds into the banking system. In contrast, when the central bank ‘tightens’ the money supply, it sells securities on the open market, drawing liquid funds out of the banking system. The multiplier effect then leads to a contraction of the money supply.
Open market operations are influencing interest rates
Then you may wonder how OMO helps transmit its impact on interest rates. The most crucial interest rate impacting all economic activities is the interbank rate at which a bank lends reserve balances to other banks on a short-term basis. The corresponding overnight interbank rate in the US is called the federal funds rate. Such rates can be considered as the banks’ costs of funds.
If an open market purchase is done by the central bank, the rise in aggregate reserves allows banks to have more funds available to lend and borrow. This can push the interbank rate downward, thus lowering the cost of funds. This will help push down all other interest rates paid by households and businesses, such as prime rate and mortgage rate. Open market sales, on the contrary, helps shrink the aggregate reserves, and pull the interest rates upward in the market.
OMO helps the central banks achieve more high-level goals such as stabilising inflation and maximising employment. Open market purchases is an expansionary policy in nature as it stimulates investment through lowering the costs of borrowing. It can fuel up the economy during economic downturns. Open market sales is contractionary in the sense that high interest rates discourage these economic activities. If the inflation is higher than the desired target, a central bank would try to slow down the growth of money supply through open market sales.8
More Insights on the Essence of Money
And now you know where the money supply is coming from and why not all money is equal. If you want to learn more about the basics of macroeconomy, also check out our articles on the history of money and decentralised finance as an alternative financial system.
References
1. Ali, Robleh. The Economics of Digital Currencies. Bank of England, Sept. 2014, www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/quarterly-bulletin-2014-q3.pdf
2. Kagan, Julia. “Fractional Reserve Banking.” Investopedia, Investopedia, 29 Jan. 2020, www.investopedia.com/terms/f/fractionalreservebanking.asp
3. Keister, Todd and James J. McAndrews. “Why Are Banks Holding So Many Excess Reserves?” Dec 2009. https://www.newyorkfed.org/medialibrary/media/research/current_issues/ci15-8.pdf
4. Board of Governors of the Federal Reserve System, Mar. 2020, www.federalreserve.gov/monetarypolicy/reservereq.htm.
5. Mehrling, Perry. The Inherent Hierarchy of Money. 25 Jan. 2012, ieor.columbia.edu/files/seasdepts/industrial-engineering-operations-research/pdf-files/Mehrling_P_FESeminar_Sp12-02.pdf
6. “Money Supply.” Wikipedia, Wikimedia Foundation, 24 Mar. 2020, en.wikipedia.org/wiki/Money_supply
7. “Monetary Aggregates.” Trading Pedia, www.tradingpedia.com/forex-academy/monetary-aggregates/
8. Hopper, Laura. “What Are Open Market Operations? Monetary Policy Tools, Explained.” 21 Aug. 2019.
