Understanding the Money Supply – Part 2: Narrow Money and the Quantity Theory of Money
Stepping Up to the Next Rung of the Liquidity Ladder: The Money Supply, Narrow Money, and Why the Quantity Theory of Money Misses the Mark
I started my exploration of the money supply in ’The Money Supply and The Role of Central Bank Reserve Accounts - Part 1: Base Money’, where I explained that money is categorised by how ‘liquid’ it is—i.e., how easily it can be used to buy things or pay for services. I focused on the most liquid form of money, called base money (also known as M0). If you are new to this ‘money supply’ topic, I recommend starting with that article.
Assuming you now regard yourself as an expert on base money, it’s time to take the next step up on our ‘liquidity of money’ ladder. In this article, we’ll learn about the level of liquidity called narrow money—also referred to as M1 or, in public discussions, the money supply. To give this article a focus, I will explore narrow money through a discussion of the ‘quantity theory of money,’ a monetarist theory linking ‘excessive’ government spending to inflation.
Note that the precise definition of the money supply can vary depending on the context. For this article, when I mention the money supply, I am generally referring to narrow money. However, be aware that it is often used as a general phrase encompassing all levels of liquidity. For example, I use it in that way in the title of the table below.
The Liquidity of Money - An Overview of the Money Supply
To provide some context for our discussion, I have created the table below which summarises the names and definitions of the different levels of money liquidity. You will notice that narrow money is the second most liquid level in the money supply. It consists of the money we use every day to pay for goods and services, whether that’s the physical cash in our purses/wallets or the digital cash we use when paying by card.
A Focus on Narrow Money
Economists focus on narrow money when discussing parts of the economy linked to cash and funds that can be spent immediately—i.e., funds that don’t need to be converted from less liquid assets, such as fixed-term savings or bonds. Topics related to narrow money include: inflation, monetary policy, the demand for money, liquidity preference (the public's tendency to hold cash rather than other forms of money), payment systems, the velocity of money (how often a unit of currency is used to purchase goods and services within a given period), and the topic I discuss in this article, the quantity theory of money.
The Quantity Theory of Money
The quantity theory of money relates to a belief expressed in the phrase, "inflation is always and everywhere a monetary phenomenon."i.e., inflation is fundamentally caused by excessive growth in the money supply relative to economic output. The phrase is attributed to leading monetarist economist Milton Friedman.
Contrasting Monetarist and MMT Views on the Money Supply and Inflation
The quantity theory of money is useful to explore because it highlights significant differences between monetarist/orthodox economic and MMT proponents, especially on topics such as the role of government, the causes of inflation, and the use of fiscal policy.
It’s helpful to note that monetarist beliefs relating to the quantity theory of money are tied to their broader ideological views. These include: support for free-market principles, small government, the primacy of market forces, balanced budgets, limited government debt, and the idea that taxes fund spending. Crucially, for the focus of this article, monetarists believe that the government largely controls the money supply and, therefore, is primarily responsible for causing inflation by "printing too much money.”
When discussing the government 'printing too much money,' monetarists are typically referring to government spending that is not offset by sufficient tax revenue (i.e, taking money out of the economy via taxes) or bond sales to ‘mop up’ the excess money in circulation. This, they argue, is what leads to inflation. It is the government's profligate spending that increases the money supply beyond the economy's capacity to produce goods and services.
In short, monetarists are referring to deficit spending. MMT advocates agree that deficit spending expands the money supply; however, they do not believe this is necessarily a bad thing or that it automatically leads to inflation.
Here come the helicopters, dumping money directly into your back pocket
Monetarists use the phrase, ‘helicopter money’ as a metaphor for central banks directly injecting money into the economy. The term was popularised by Milton Friedman in his 1969 paper "The Optimum Quantity of Money". He used the image of dropping money from a helicopter to illustrate the effects of an arbitrary increase in the money supply.
As much as I admire the strength of the metaphor, it does suggest that nothing exists on the other side of the financial transaction—no exchange for goods, services, or investments in productive capacity. It conjures an image of the government literally throwing dollar or pound notes out of a helicopter, with no regard for where they land or what they achieve. While it is a powerful way to illustrate the monetarist view, it fails to account for the additional productive capacity or economic value that can result from the government spending. This spending, if directed towards infrastructure, public services, or job creation, can expand the economy's ability to produce goods and services, mitigating any additional spending power.
For MMT advocates, the concept of helicopter money oversimplifies monetary operations, downplays the importance of fiscal policy as a tool to manage the economy and overlooks how targeted spending can enhance productive capacity.
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MMT Advocates Point Out That the Government Is Not in Control of the Money Supply
MMT advocates disagree with the monetarist view that the government is the primary controller of the money supply, arguing that most money in the economy is created through the borrowing and spending decisions of businesses and households. MMT economists emphasise that private banks create money when they issue loans. While acknowledging that government deficits expand the money supply, MMT highlights that it is the demand for loans that primarily drives the money supply—up or down—rather than government actions.
Monetarists do acknowledge the role banks play in creating money through lending; however, they again place the blame for any excessive bank lending on the government, arguing that this is due to the government failing to regulate banks effectively. Specifically, they claim that governments are too lax in controlling what they call the 'money multiplier.' The money multiplier is the idea that bank lending is limited by the amount of reserves banks have access to in Central Bank accounts—essentially, that banks can only lend a fixed multiple of the reserves they hold. In their view, this failure has allowed banks to create more loans than the economy can sustain.
In Practice, Bank Lending Is Not Constrained by Access to Reserves
MMT economists point out that in practice, bank lending is not constrained by access to reserves but by the availability of profitable and creditworthy lending opportunities. Banks do not limit their lending based on the so-called 'money multiplier’, i.e., the idea that they can only lend a fixed multiple of the reserves they hold. Instead, lending creates deposits, and reserves are adjusted after the fact to ensure the banking system functions effectively.
The Quantity Theory of Money and Bond Sales
Monetarists advocate the use of bond sales (in addition to taxes) to remove excess money from the economy as a way to reduce inflationary pressures. However, as noted above, bond sales are merely an asset swap: exchanging government bonds for an equivalent amount in reserves. While both reserves in the US and the UK now pay interest (the Central Bank did not pay interest on reserves in the 1980s), bonds are attractive because they offer a higher rate. Bond sales do reduce reserves but this reduction does not constrain the ability of commercial banks to make loans. Bank lending is determined by the availability of creditworthy borrowers and profitable lending opportunities, not by the quantity of reserves.
MMT Challenges the Monetarist View That Inflation Is Always and Everywhere a Monetary Phenomenon
According to MMT advocates, inflation is not just a result of the quantity of money but on the real capacity of the economy to produce goods and services. When the economy is at full capacity, further increases in the money supply can lead to inflation. However, when there are unused resources (such as unemployed labour), governments can increase spending and inject money into the economy without necessarily causing inflation.
MMT focuses on the real capacity of the economy—how many goods and services it can produce, and whether it has unused resources like unemployed workers or idle factories.
In fairness to Friedman, he acknowledged later in his career that direct government control of the money supply proved to be ineffective. This became clear in the 1980s when policies aimed at targeting the money supply failed, due to, among other things, the government’s inability to control money creation by commercial banks.
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Thanks,
Jim
Hi Jim - in the table above (Base Money 3rd column) you say: "Central Bank Reserves are deposits commercial banks hold at the central bank. Base Money does not include commercial bank money"
I would have thought that "commercial bank money" is the money the bank uses for its own operations, which is held in its reserve account. In other words it has one reserve account which combines transactions for itself as well as its customers.
Am I misunderstanding what you mean by "commercial bank money" or do banks have two accounts with the CB, one for their own purposes and one for customers and inter-bank movements?