True Money Supply

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.

Retail Sweeps

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:

Click image to enlarge.

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10 thoughts on “True Money Supply”

  1. Nima,

    I have been thinking about this a lot. Excellent as usually. My mind always goes directly to how can I place a trade based on this information. Which lead me to something that might add additional insight into this. But, not exactly sure if it isn’t already accounted for. Excess reserves held at the Fed. Don’t you need this factored into the money supply figure in order get a true figure? This would be an excellent indicator of a switch from the inflation/deflation debate since this is really the only thing dividing the debate, in my opinion. Am I off base or did you already take that in to consideration and i don’t understand?


  2. No, I am not factoring this in, precisely because it is not in circulation. Imagine a bank had excess reserves buried in its backyard, never to be taken out, ever. Would you count that in as part of the money supply?

    To be sure, once they do lend it out, it goes into demand deposits and it will be accounted for.

    The main divide in the inflation/deflation debate is not so much what is and what is not to be included. It really is the idea that credit claims have to be included when determining whether we are in an inflation or deflation.

    Did you read my post ? It is of crucial importance when it comes to the inflation/deflation debate.

  3. Thank you for pointing that entry out to me and Prechter’s PDF. I enjoyed both. I see why you wouldn’t put it in the money supply. I was thinking about the potential for banks to lend and wanting to handicap an indicator, but after reading what I wrote it seems I was trying to make the case for it to be included in the true money supply. Didn’t mean for it to come out that way. I keep a close eye on this report:
    Mainly, to get an idea of supply and demand in the loan market and was thinking with all the excess reserves(assuming they are truly available to be lent out) if we saw the loosening of credit standards and a widening of the spread that banks receive, that it would setup an opportunity for a lot of activity. Which could lead to re-inflating and inflation quickly. But, the demand numbers for loans don’t even look like it bottomed yet, so ties right back into what you said in the revisited post. Thanks again.

  4. It is interesting to have such a report that shows you the demand for loans. I am not quite sure I get the titles 100%. What does “Net Percentage of Domestic Respondents Tightening Standards for …” mean?

    Yes, if there is no demand for loans the banks could have hundreds of trillion dollars in excess reserves and it wouldn’t do anything at all. All they would do is to try and repay loans that generated the excess reserves to get them off their balance sheet. For example right now you can see that banks are scrambling to repay TARP money.

    The demand for loans, the willingness of people to incur more debt, their belief that they will be able to earn enough money in the future to pay it off, this is what ultimately determines the banks’ potential to lend, not how much they have in excess reserves.

    When people have had enough Jaguars and are sick and tired of them, then there is no more potential for sellers to sell any more Jaguars.

    And when people have taken on enough debt and are sick and tired of it, then there is no more potential for banks to lend any more money.

    If other means existed for the banks to inject money, like having them buy anything they desire with it, not just debt instruments, then you would most definitely get a hyperinflation, but not in an environment where their only means of injecting money is by buying up debt…

  5. This report is a survey of approximately sixty large domestic banks and twenty-four U.S. branches and agencies of foreign banks. So, if they say 80% of the respondents are tightening standards for loans, it simply means they are making it tougher to get loans. I couldn’t agree more that banks are not going to take risks unless they see they can make money, that is why the spread chart of loan rates vs costs of funds is so important. This highlights the ability for a bank to make money. I fully understand the Jaguar analogy, however this doesn’t account for adding productivity to the economy. Like when you analyze a company, you need to look at both ROE and ROA then ROA vs Cost of Capital. Does a company produce more when they have leverage? Is there a growth of debt that would hamper a companies ability to grow? What if banks loosen the standards to make loans at the same time they are getting a bigger spread to take a risk. Entrepreneurs will have a price at which they will want to take a risk and incur debt to start or grow businesses again. We need to separate consumers from businesses in this debate as well. I agree consumers appetite is going to be very limited, but business? Corporate profits always turn up before we leave a recession.
    then, businesses start investing
    then consumers will eventually gain their footing. However, none of that can start unless banks have a healthy spread and they start to lower standards. Lastly, part of the reason banks lower rates is that they see corporations firming up their balance sheets, then banks pick the strongest corporations to start loaning to, which gives us the footing for a recovery. Not sure we are there yet and still may have a ton of unwinding to do, but this is perfectly in line with your description of the business cycle.

  6. does the sweep (is it true??) mechanism as you claim change the money supply at all or just change how it money can be used???

  7. The sweep mechanism doesn’t change the amount of money available for spending on your bank account at all.

    But what it does it it categorizes a certain amount of checking account money on your bank account as savings money, even though it’s not.

    So the final data reported on money in US checking accounts is too low, since part of it has falsely been classified as savings money.

    But I want to capture all money in US checking accounts because I consider that a part of the money supply.

    So that’s why I add the amount “swept” back in.

  8. You are conflating money and credit.

    Ours is a legal tender monetary system, this necessarily means that our money is defined by law, and nowhere in law will you find the debt-based private credit generated by the Federal Reserve and the U.S. banking system being designated or even acknowledged as being a U.S. legal tender, or a money of any type. Also, there is no law that grants to either the Federal Reserve or the banks the authority to create money, that is a right/privilege retained by the U.S. Federal Government.

    You are confusing a means of payment, the transfer of a debt obligation (credit), for the medium of exchange, what is owed as payment (an asset). By legal definition, United States coins and currency, including Federal reserve notes, are legal tender money, a medium of exchange (the asset) by law. Checks as well as debit cards, credit cards, money orders, etc., are a means of payment, referred to as a generally accepted (institutional) arrangement or method that facilitates delivery of money from one to another. Payment has not been made unless or until actual money proper has changed hands. All credit is debt outstanding.

    Basically, using a debit/credit card is the same as writing a check, an order to the bank to transfer money to the payee. The payee’s receipt acknowledgment of a completed transfer means that the money (as defined by law) is at their bank and available for withdrawal.

    The notion that we’re using ‘digital money’ or ‘digital currency’ or ‘digital dollars’ or ‘credit dollars’ or ‘credit money’ (an oxymoron) as a medium of exchange is nothing more than a trick of the mind, a figment of our overactive imaginations, a deception, it’s how we rationalize the transaction, and it’s how the banksters get away with stealing our labor and wealth.

    There is no money in any deposit account of any type anywhere in all of ‘westernized banking’, they are all ‘credited accounts’, bookkeeping entries denoting the amounts of money owed to each account holder by the bank. In other words, they are all bank debt.

    Currently, there are only $1.48-Trillion in U.S. legal tender money (the True Money Supply) in circulation around the globe, with about $280-Billion of that in circulation within the U.S. and $71-Billion of that, in bank vaults. All the rest, about $11.52-Trillion erroneously referred to as ‘money’, is nothing more than Fed and bankster generated asset-backed, debt based private credit, not money, not U.S. Legal Tender, it is their debt to the American people. (And that’s why they want to ban cash.) By the way, that $71-Billion of legal tender in bank vaults, backs the $11.52-Trillion in non-monetary bank generated debt based private credit, and that’s what is known as ‘fractional reserve banking’.
    the Frog

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