What is the money supply?
Definition of the money supply
The money supply is the volume of money in circulation at a given time T. It is the monetary authorities (central banks) that determine how much this volume should grow. The money supply is therefore derived from monetary policy. Aggregates are used to measure the money supply.
Monetary aggregate: Unit of measurement for the money supply
Let us define what is meant by these aggregates:
Monetary aggregates in the strict sense: They are all the means of payment held by agents. These aggregates are divided into 2 subcategories. The first is fiduciary money (coins and banknotes), which is valued by the trust placed in it. The second is scriptural money (cheques, etc.) which is valued through an accounting entry.
Monetary aggregates in the broad sense: These are aggregates in the strict sense and all financial assets that can be transformed into immediate means of payment (savings account, etc.)
Investment aggregates: This is sustainable savings such as PEPs, treasury bills, etc.
Aggregates are therefore differentiated by their components degree of liquidity, from the most liquid to the least liquid. In the official language of central banks, here are the different aggregates:
M1: Banknotes + coins + demand deposits (current account)
M2: M1 + short term deposits + PEL + Codevi
M3: M2 + Term deposits + UCITS + MMF + treasury bills + commercial paper
Today, the money supply is becoming less and less liquid because the less liquid the money is, the higher it is remunerated. However, the concept of money supply is not limited to liquid forms of money. It is also necessary to take into account the investment aggregates that constitute a purchasing power reserve for economic agents. (Called P1, P2, P3).
It should be noted that the aggregate used by the central bank to define its monetary policy is M3. Money creation must not be abusive because it results in inflation. However, not all central banks set themselves a limit and their main objective is not to fight inflation but rather to grow their economies.
The notion of the money supply’s counterparty
All money is created as a function of counterparties. Counterparties are the source of money creation, they explain on which occasions money was created. There are two types of counterparty:
Net external receivables: The inflow of foreign currency into a country increases the money supply. All currencies held by financial institutions are then taken into account. Gold is also a counterparty.
Net internal credit: These are claims on the public treasury held by the central bank
Receivables from the economy: These are all the credits granted to economic agents by the State. Effectively, credit is about granting purchasing power that did not exist in the first place.
The mechanisms of monetary creation
Two mechanisms explain monetary creation:
The deposit multiplier: This is the fact that the credits of one entity make up the deposits of another. . Banks collect savings of various maturities from economic actors. These banks then use these deposits to provide loans. Economic agents are therefore involuntary lenders. The bank is an intermediary that plays a transformative role. It converts (sometimes short term) savings deposits into long term loans. Part of this credit (most of it used for consumption or investment) could potentially be deposited in the same or another bank. The bank receiving a new deposit can then grant a new credit. This is one of the mechanisms of monetary creation. This phenomenon can therefore be described as automated because banks unintentionally create money supply.
However, this mechanism is controlled by the central banks. Effectively, commercial banks are not allowed to lend the full amount of the deposit they receive. A portion must be set aside (fraction given by the mandatory reserve rate). It is one of the most important instruments of monetary policy in the United States. Moreover, the money put in reserve is not remunerated, unlike the ECB, which remunerates the commercial banks' reserve accounts. The central bank only has to increase the reserve requirement ratio to reduce the increase in the money supply,
The credit divider: This is the mechanism of monetary creation through debt. Commercial banks try to maximize their profits and therefore want to grant maximum credit. They can obtain money or deposits by borrowing from the central bank. The central bank cannot refuse to lend to a bank because of its role of lender of last resort. This refinancing of banks is not free of charge and it is the central bank's refinancing rate that will be applied. So, the lower the policy rates, the greater the amount of money created. However, the amount that commercial banks can borrow from the central bank is not unlimited. Each week, the central bank allocates an amount to be apportioned, based on the commercial banks that offer the highest rates.