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Wednesday, November 30, 2016

Primer: Monetary Aggregates

Mysticism about money is damaging to economic theory. This shows up in even the most fundamental questions, such as defining what “money” really is. It is clear that the developed countries are “monetary societies,” and behaviour is very different from those societies where money is either not used or highly ceremonial in nature. Unfortunately, our usage of the word money is often muddled, as we say things like “she made a lot of money selling used cars,” even though what we really mean is that “she earned a high income selling used cars.” For those with an interest in describing macroeconomic behaviour, such vagueness is not enough; we have to pin down what we mean by money.

If money were to be abolished from economic theory, the only references to money might be in reference to the monetary aggregates. This primer explains the definitions of these aggregates (without diving into the institutional differences between different regions).

(Note: this article is an unedited excerpt from the upcoming Abolish Money (From Economics)!)

Monetary Aggregates

Different jurisdictions have slightly different definitions of monetary aggregates, reflecting different institutional and accounting norms. The aggregate definitions start with an aggregate with the narrowest list of instruments, and then later aggregates add more instruments. These are usually labelled M0, M1, M2, M3, with M0 being the narrowest definition. It is also referred to as the “monetary base” (or “base money”).

The European Central Bank uses the following broad definitions for M1 - M3 (link).

  • M1: currency in circulation (notes and coins), and overnight deposits.
  • M2: instruments in M1, plus deposits with an agreed maturity up to 2 years, and deposits redeemable at a period of notice up to 3 months.
  • M3: instruments in M2, plus repurchase agreements (“repos”), money market funds, and debt instruments up to 2-year maturity.

The definition of the monetary base (“M0”) is not given by the ECB, but for Canadian data, the definition is “notes and coin in circulation, chartered bank and other Canadian Payments Association members' deposits with the Bank of Canada” (from CANSIM table 176-0025).

The Canadian definition of the monetary base is similar to that for the United States, but there is a key practical difference. In Canada, banks are not required to hold deposits at the central bank (the Bank of Canada), while in the United States, banks are required to hold reserves at the Federal Reserve banks. This means that the definition in the United States would be modified to include “required reserves and excess reserves” (excess reserves are deposits at the central bank in excess of reserve requirements, which are based on the size of bank’s deposit base).

Although it may not be obvious, the size of the monetary base is (roughly) equal to the size of the liabilities on the balance sheet of the central bank, since the instruments in the monetary base are liabilities of the central bank. (Some people object to viewing the monetary base as being a “liability” for various reasons, but redefining it as anything else makes discussing the accounting difficult to understand.) However, not all liabilities of the central bank are including in the monetary base, such as money deposited by the Treasury. That said, we can summarise the situation by saying that operations that expand the central bank’s balance generally expand the monetary base (the exceptions being things like intra-governmental borrowing).

Since a central bank in a floating exchange rate regime generally has control over which transactions it enters into, we can say that the central bank has control over the size of the monetary base. (If the currency is not free-floating, the central bank can be forced to undertake operations to preserve the currency peg. For example, it might be forced to buy/sell gold as part of a gold peg. In which case, the central bank has only partial control over the size of its balance sheet.) The extent of that control is a point of debate within economics (known as “endogenous money” versus “exogenous money” in economist jargon).

Relating Aggregates to Economic Activity

The only reason to care about monetary aggregates is that we can relate them to other economic variables. By themselves, they are only of interest to accountants (“how many currency notes did we print, anyway?”).

The Quantity Theory of Money in its simplest form argues that we can directly relate the price level in the economy to the money supply. However, the simplest version of the theory (in which increases in the money supply create proportional increases in the price level) can be rejected by the empirical data, using any of the monetary aggregates to stand in for the vaguely defined “money supply.” However, it is possible to conceive of more complicated relationships between monetary aggregates and the price level, in which increases of money translate into inflation “in the long run.” Monetarism was an influential body of economic thought which tried to find such relationships.

Attempts to validate such a relationship explains why there are so many monetary aggregates. Since existing aggregates failed to have predictive powers, new aggregates were developed, which were supposed to cover up the defects of the existing aggregates by adding in new “monetary” instruments. However, these new aggregates also generally failed to be useful as well. As a result, the attractiveness of Monetarism collapsed (although a few rebranded “Market Monetarists” remain), and most analysts pay little attention to the monetary aggregates. The empirical relationships are discussed in “Instability of Money Velocity” and “Should We Care About Money Growth?” (Note: These have not been previously published; early versions of the analysis appear here and here.)

Concluding Remarks

Discussions of “money” within macroeconomics are often detached from reality. We need to define a monetary aggregate that we wish to analyse, and then attempt to see whether it provides any useful information about economic behaviour. In general, we find that the information provided is extremely limited, which explains why monetary aggregates are now rarely discussed in market analysis.

(c) Brian Romanchuk 2016


  1. "We need to define a monetary aggregate that we wish to analyse, and then attempt to see whether it provides any useful information about economic behaviour. In general, we find that the information provided is extremely limited..."

    The monetary aggregates are already pretty well defined: M1, M2, etc, as you point out.

    I get some pretty useful information comparing broad money to narrow. But I could put up a graph of TCMDO relative to M1SL and call it "debt per dollar", and somebody would stop by to tell me "all money is debt".

    1. This article does not go into the empirical analysis; I do some graphical analysis in other articles in the book. (Preliminary versions are linked to above.) I found that you could get some information from the money numbers, but the relationships are unstable. I have my doubts that they provide much more information than other credit aggregates. Meanwhile, the monetary aggregates are lumping together instruments that probably should not be aggregated.

  2. I posted three research papers on SSRN that attempt to specify a four sector model of the United States financial system. In this system the monetary aggregates would be a sensible metric when restricted to the mix of liabilities issued by the aggregate Bank sector. The reason this is sensible is that the aggregate Bank sector grows its assets and liabilties via credit interactions with the central bank, central or federal government, and with the aggregate Nonbank sectors of the economy.

    When the Post-Keynesians or Circuitist economists say, "Loans create deposits" this means the aggregate Bank sector generates bank credit assets by extending loans to Nonbanks (including state and local governments) and it increases the float of transaction accounts (checking deposits) in the so-called M1 money supply. But if a bank must clear payment on the loan to another bank, it must transfer reserve assets to another bank, which means it must generate a flow of reserves in its favor large enough to clear payment on the loan. This means the banks expanding loans will offer liabilities in the so-called M2 and M3 money supplies to keep reserve payments flowing in the interbank system. During the 2007-2008 financial crisis the banks in the United States experienced a "run" away from investments in their repurchase agreement liabilities and away from investments in their uninsured large time deposit liabilities. Because the quality of bank assets (loans) was in question, the aggregate Bank sector would have problems issuing M2, selling equity as paid-in capital, or securing long term debt borrowing, so the result would be a spike in M1 transaction accounts as liabilities in M2 or M3 fail to rollover on the aggregate Bank balance sheet. The interbank payment mechanism would no longer generate a flow of "free" or "excess" reserves and the central bank (US Fed) would be forced to provide reserves as the lender of last resort. So I think it is very useful and significant to track M1, M2, M3, and other bank liabilities to understand that the interaction between the aggregate Bank and Nonbank sectors is driving the price of assets and equity via deals made in M1, M2, M3, and other bank liabilities. The correlation models to GDP or other "real economy" factors do not correlate well because the mix of aggregate Bank liabilities is flexible enough to change over time as long as there is not a money market crisis at which time it is no longer a flexible mix and the aggregate Bank cannot rollover its liabilities or raise equity to keep interbank payments and bank assets growing.


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