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John Hearn blog: Money, money, money - supply, creation and demand

31 May, 2016John Hearn

How do you separate the money supply from monetary demand? John Hearn takes a look at the different concepts of money, money supply, money creation and money demand and how this has changed over the centuries. 

I tell my students that if they want to impress people at parties then they should recite Walker`s definition of money:

“…that which passes freely from hand to hand in full payment for goods, in final discharge of indebtedness, being accepted equally without reference to the character or credit of the person tendering it, and without the intention on the part of the person receiving it to consume, enjoy or otherwise use it than by passing it on sooner or later in exchange.”

It is a showstopper of a definition and it explains that an efficient money has to be generally acceptable in transactions, a useful unit of account and can maintain its value into the future.

Like all economists I will move to the next stage by making an assumption that before today`s fiat money there was only one type of money and that was gold. The difference between early forms of money like gold money is that gold had both value in use and value in exchange, whereas fiat money has no value in use, just value in exchange.

The story goes that in the 17th century Jewish emigres from Europe set themselves up as goldsmiths in London. They worked with gold and had vaults to keep it safe. By the time of the English Civil War, which started in 1642, the goldsmiths realised there was an opportunity to earn more by offering to look after people's gold. As time went by goldsmiths' paper receipts were used as money as they were being passed from one person to another in trade and were effectively transferring the ownership of gold. Goldsmiths soon realised they could improve their service by offering more than one receipt in different denominations e.g. 1, 10, 20 etc. This meant that the receipts were taking on all the characteristics of money. However all of this money was backed 100% by gold, so the goldsmiths were just depositories and no new money had been created.

As people were using goldsmith receipts as money there was a lot of gold (surplus to requirements) in their vaults, and a lot of respectable borrowers and governments who wanted to borrow money. Seeing another opportunity the goldsmiths turned themselves into bankers and started lending out some of the gold that was laying idle in their vaults. The people who borrowed the money were unlikely to want the gold as the goldsmiths receipt was as good as money and a lot easier to use in trade. At the point that borrowers are happy to use receipts, new money is being created as there was now more money receipts in circulation than gold to back them.

Gradually as confidence built, more new money was created and by the early 20th century, there was a monetary system which was fractionally backed by gold with private banks and the Bank of England involved in money creation. The current system is similar except that the Bank of England has suspended your access to gold, or some may say even stolen gold from its rightful owners, and the money supply is now fractionally backed by cash not gold

If we come right up to today, how do we separate the money supply from monetary demand? It is reasonably simple in as much as the money supply is a stock concept whereas monetary demand is a flow concept. At one point in time, it is relatively easy to make a crude estimate of the total money supply by adding cash in circulation to all bank current accounts. In the banks' accounts it will be possible to identify the proportion of cash they are holding to total assets. We now have a money supply that is comprised of a cash base and credit money, and a banking system with a ratio of cash to assets of about 5% cash and 95% credit money. In the past the banks had been requested by the Bank of England to hold an 8% cash to total assets ratio, but this was abandoned early in the 1970`s. However, this ratio is now determined by an estimation of expected customer demand for cash. It is necessary to keep sufficient cash so that the bank does not end up like Northern Rock, which was unable to satisfy unexpectedly high demand for cash.

During normal times there is a fairly consistent relationship between the amount of cash held by banks and the amount of loans they create. This means that a change in the cash base can influence the amount of loans a bank can support: more cash means potential for more loans and less cash means that the loan book will shrink. Although it is much more complicated than set out here, we can deduce a multiplier calculation that will maintain the same cash ratio if the size of the cash base changes. This simple example makes the point.

Suppose there is a single bank with many branches and no cash drain to the public when changes occur. The bank has decided to keep 12 ½% of its assets in cash and a new deposit in cash of £1000 is made at the bank. Using the formula 1/ cash base ratio = multiplier, what effect will this change have upon bank lending? If you get the answer £7000 then you understand credit creation, if you do not then you have a little more work to do.

Double entry bookkeeping at the bank means that a new loan is also a new deposit, but at the end of the day it is only an increase in the money supply if there has been a net increase in loans. A further point to note is that once created the money is used repeatedly in trade and becomes divorced from the original money creation process. Unfortunately this means that banks are too important to fail as the destruction of deposits removes the unit of account required in trade. However there may be good reason to sack the board and the management, and this is one of the useful things a Central Bank can achieve in its regulatory role.

We have now covered money, money supply and money creation and we need to explain how the money supply measures up against monetary demand. Remember that money supply is a one point in time stock concept while monetary demand is an overtime flow concept. Because the same units of money are passed on time and time again in trade we can deduce the following: if the money supply is £100 and over a period of time it is used in £500 of transactions then the velocity of circulation of money is five, i.e. on average each unit of money has been used five times, and money supply x velocity of circulation = monetary demand.

I have stated in other writings that a Central Bank can control the level of monetary demand in an economy. Whether they choose to or not is another matter. They have three main options: they can manage the amount of cash in the system, or they can manage the level of bank lending using interest rates, or they can try to influence the velocity of money circulation. They have total control over the supply of cash if we ignore counterfeiting. They have much less control over bank lending and by using interest rates they can create distortions like the current asset bubbles. Lastly they have virtually no control over velocity which is influenced more by people`s perceptions of inflation and deflation. Taking everything into account the Bank of England should manage cash and the volume of money, but unfortunately chooses to try and manage the ones it cannot manage as well.

John Hearn is a lecturer for the 'Financial Services: The Commercial Environment' module at ifs , and an author.