Modified: February 09, 2022
money supply
This page is from my personal notes, and has not been specifically reviewed for public consumption. It might be incomplete, wrong, outdated, or stupid. Caveat lector.Naively you might think that the government just decides how many dollars there should be, and that's that. This is not true. Since IOUs are money, lots of money is created by non-government entities. Different 'types' of money are created by different types of entities.
M0: physical currency printed by the government.
MB: the previous, plus the total bank reserves held by the central bank.
M1: the previous, plus all bank deposits (money created by regulated banks through fractional reserve banking).
M2: the previous, plus money market accounts.
M3: the previous, plus eurodollars (money created by foreign banks) and some other stuff.
M4-: the previous, plus commercial paper (money created by non-bank companies).
M4: the previous, plus treasury bills (money created by the government).
These days we should also include stablecoins as part of the expanded money supply.
How can a central bank control how much money exists?
- The bank can directly inject money into the economy by buying treasury bonds. That is: the central bank creates money out of nowhere and deposits it in the treasury, where the government can use it to finance its operations. In exchange, the government gives the central bank an IOU (the treasury bond).
- Similarly, the bank can remove money from the economy by selling treasury bonds---literally, asking the treasury to give it money to cancel out existing IOUs. This reduces the amount of money in the treasury, meaning that the government must either reduce spending or raise taxes to compensate.
- The multiplier from money created as loans in fractional reserve banking can be controlled directly via reserve requirements, or indirectly by setting interest rates.
Q: How (why) does the money supply increase when new value is created?
- A1: If we were on the gold standard (or something analogous like a Bitcoin standard), it wouldn't. The amount of money in the world would be fixed, and value creation would lead to deflation (lower prices).
- A2: The central bank uses the above tools to attempt to maintain price stability and support economic growth.