No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Twelve: Money Mischief 278 said “he’s got a lot of money,” you might understand I am referring to money much more broadly. I am also likely being imprecise in my terms, by making money synonymous with wealth. Yet, some of our broader money aggregates are components of wealth as well, so it can get confusing. In Figure 12.1 you can see the inverted pyramid of the money supply. As we saw in the last chapter, when the Fed provides reserves to the banking system, it allows multiple deposit expansion to take place. Any purchase of securities by the Fed increases the reserves that banks have in their accounts at the Fed, and any sale of securities by the Fed reduces the amount of reserves in the banking system. The monetary base (MB), which we more loosely called high powered money in the last chapter, consists of bank reserves (R) held at the Federal Reserve and also any currency or coins held in bank vaults or with the general public (C). Therefore, We saw in chapter 11 that when the monetary base is expanded by Fed purchases of securities, additional loans can be made and checkable deposits created with the new loans. Checking accounts are a form of money, and our next category of money, M1 , includes currency plus checkable deposits (CD). M2 is broader still; it includes all aspects of M1, plus savings accounts that are quickly and easily converted to cash (TD, for time deposits), or have check writing privileges like money market mutual funds (MMMFs), which we’ll include as a type of money market accounts (MMA). So M2 can be thought of as… A final monetary aggregate is M3, which includes all types of money found in M2, plus large time deposits (>$100,000), institutional money market funds (MMMFs held by large banks, insurance companies, etc.), and various foreign dollar denominated assets. The Fed no longer tracks this aggregate nor tries to target its value. Nevertheless, some economists find it useful to continue tracking M3 to understand how monetary policy affects the broader money markets. M1: a “narrow” form of money, consisting of highly liquid (easily converted to cash) instruments. M1 includes government base money as well as money created by the banks’ multiple deposit expansion. M1 = Currency + Checkable Deposits + Other Checkable Deposits (interest bearing) + Traveler’s Checks. M2: a “broader” form of money, including all the components of M1 but adding small savings accounts that are easily converted to narrower money. M2 = M1 + Savings Deposits + Small Time Deposits (<$100k Certificates of Deposit) + Retail Money Market Funds. Monetary base: the narrowest form of money in a fractional reserve banking system (also called high powered money), consisting of Currency (C) and Reserves (R). Multiple deposit expansion: the process of money creation, enabled by a fractional reserve banking system as new reserves are provided by the central bank. M3 M2 M1 MB Figure 12.1, Money Pyramid. The money supply creation process begins with the monetary base (MB); without this foundation, no new money can be created. As you move up the pyramid, the Federal Reserve’s direct influence decreases, but the broader aggregates (M1, M2, & M3) tend to be more stable. MB = C + R M1 = C + CD M2 = M1 + TD + MMA