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 AggregatesDifferent 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 ActivityThe 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.)