The money supply inside a country is the total nominal value of money units ready to be spent in its respective territory. Money is a medium of exchange. This is its ultimate purpose. All other so called money functions, like value storage medium, measure of utility, etc. are nothing but derivatives of this function. More precisely, money is that medium which is accepted by virtually everyone inside a certain territory as a medium of exchange for products and/or services rendered.
As explained in Credit Expansion Policy, the major business cycles, booms and recessions are caused by an increase and subsequent drop of the money supply, respectively.
If one carefully tracks the true stock of money and its growth or contraction over time, one can make fundamental assessments and predictions about the state of the economy and the outlook for asset and consumer prices in general.
The Federal Reserve Bank employs two measures for the money supply: M1 and M2. It also supplies other data, called ‘Other Memorandum Items’ which in its opinion is not part of the money supply.
We shall analyze each component of the data provided, and figure out whether or not it should be included in the money supply.
A lot has been written about the true money supply. There are completely different views on this matter. However, the solution to the question is pretty simple so long as one agrees that the definition of money is that it is the medium of exchange accepted by everyone within a certain territory.
Each component simply has to pass the following test: Is this item accepted by virtually everyone as a medium of exchange inside the USA?
M1: Currency + Traveler’s Checks + Demand Deposits + Other Checkable Deposits
Currency: This is cash money in the pockets, lockers, mattresses, or hands of individuals. Cash, when printed and used by the federal reserve to purchase assets and thus channeled into circulation increases the nominal amount of media of exchange available in society. Virtually everybody accepts cash as payment. It is without a doubt a component of the money supply.
Traveler’s Checks: Traveler’s checks are issued by American Express and other credit institutions. A traveler’s check has to be purchased in exchange for currency or checking deposits. Money is transferred from the purchaser’s account to the company issuing the traveler’s check. When used, money is transferred from the issuing company’s deposits to the person redeeming the check. Hence, traveler’s checks do not add to the overall availability of media of exchange, they are merely a means to facilitate the transfer of actualy money. Traveller’s checks are not commonly accepted as a means of payment inside the US. They are not to be included in the money supply.
Demand Deposits: Demand deposits are checking accounts. Additional checking account money can be created in different ways: When people deposit cash money in exchange for demand deposits, the overall money supply does not change. However, if we observe both figures, then all cash deposits will reduce the ‘Currency’ account, and increase the ‘Demand Deposit’ account. Another way of creating demand deposits is when the central bank issues new demand deposit money instead of printing new money, and purchases bank assets with it. In addition to that, banks may issue credit themselves by making out loans that are not fully backed by deposits. This money will appear on the loan recipient’s checking account. Checks can be written against them. Virtually everyone accepts payment in demand deposit money. Demand deposits are thus to be included in the money supply.
Other Checkable Deposits:These are savings deposits that can be drawn upon when demand deposits are overdrawn. But a savings deposit is not part of the money supply. A savings deposit does not function as a medium of exchange. When someone deposits money in a savings account the bank turns around and invests the money in credit instruments. It will then appear on the checking account of the seller of the credit instrument. This does not change when the savings deposit can be partially drawn upon. A buyer of a good cannot write a check against his savings deposits. At the best he writes a check against demand deposits that he is going to obtain after liquidating a fraction of his savings deposits. It would be rather impossible to try and use one’s savings deposits as a means of payment. No one would accept a payment ‘in savings deposits’. This even applies to that portion of it which can immediately be turned into checking account money. The recipient of a check written against the checkable portion of a savings deposit still demands checking account money as final means of payment. Thus the payer’s savings deposit dollars need to be converted into checking deposit dollars settling the transaction. (If this was NOT the case, savings deposits and other checkable deposits would indeed be a part of the money supply.) Other checkable deposits are hence not part of the money supply.
M2: M1 + Savings Deposits + Small-Denomination Time Deposits + Retail Money Funds
Savings Deposits: As explained above under ‘Other Checkable Deposits’, savings deposits don’t function as media of exchange. Nobody would accept a payment from someones savings deposit straight to his savings account. But our definition of money is that is is precisely that medium which is broadly accepted as payment. Savings deposits are hence not part of the true money supply.
Small-Denomination Time Deposits: These are deposits where the depositor contractually commits to not withdrawing the money for a fixed time frame. Time deposits cannot be used as media of exchange and are hence not part of the true money supply, even less so than savings deposits.
Retail money funds invest in short-term debt, such as US Treasury bill and commercial paper. They are not used or accepted as media of exchange, and are hence not part of the true money supply.
Other Memorandum Items: Demand Deposits at Banks Due To Foreign Commercial Banks and Foreign Official Institutions + Time and Savings Deposits Due To Foreign Commercial Banks and Foreign Official Institutions + U.S. Government Deposits + IRA and KEOGH Accounts
Demand Deposits at Banks Due To Foreign Commercial Banks and Foreign Official Institutions: These are checking account deposits held by foreign banks and institutions at American banks. Foreigners hold funds in checking accounts of other countries in order to cover expenditures in those same countries. These expenditures are covered using that country’s medium of exchange, money. They clearly are to be added to the true money supply.
Time and Savings Deposits Due To Foreign Commercial Banks and Foreign Official Institutions: As already explained above, time and savings deposits are not to be included in the true money supply.
U.S. Government Deposits: These are demand deposits held by institutions of the the U.S. Government at commercial and the Federal Reserve Bank. It is a curious fact that they have been excluded from the official money supply data. The money does not disappear from circulation. If A pays taxes to government entity B the funds are merely transferred from one account to another. The funds are used to cover expenses during day to day operations, pay employees, etc. and are hence a part of the true money supply.
IRA and KEOGH Accounts: These are, like savings and time deposits, merely investments in credit instruments and other investment vehicles and are not part of the true money supply.
One more important item to be mentioned are so called bank ‘retail sweeps’. Retail sweeps were introduced in January of 1994 when the Federal Reserve Board allowed commercial banks to use a software that classifies certain portions of customers’ checking account deposits as money market deposits accounts (MMDAs). Researchers at the regional Federal Reserve Bank of St. Louis have summarized it as follows:
“At its start, deposit-sweeping software creates a “shadow” MMDA deposit for each customer account. These MMDAs are not visible to the customer, that is, the customer can make neither deposits to nor withdrawals from the MMDA. To depositors, it appears as if their transactionaccount deposits are unaltered; to the Federal Reserve, it appears as if the bank’s level of reservable transaction deposits has decreased sharply. Although computer software varies, the objective is the same: to minimize a bank’s level of reservable transaction deposits, subject to several constraints.”
This means that customers don’t notice the slightest change to their demand deposit account. In effect, their behavior doesn’t change at all, no matter whether or not their checking deposit has been reclassified. Retail sweeps are nothing but an accounting fiction that enable banks to lower their minimum reserves and lend out more money.
But this means that the statistics on demand deposit accounts have been inaccurate since 1994. That portion which has been reported as MMDA when it was actually demand deposit money to customers needs to be included in the money supply. The Federal Reserve Bank of St. Louis provides a monthly estimate on this number. Retail Sweeps are part of the true money supply.
Conclusion: Thus the true money supply ( we shall call it M(t) ) is defined as follows:
M(t) = Currency + Private Demand Deposits + Demand Deposits Due to Foreign Banks and Institutions + Government Demand Deposits + Government Federal Reserve Deposits + Retail Sweeps
Below is the development of the true money supply from 1959 through 2008: