Fiat issuance. Money substitutes -> Money aggregates
Explain to me how the increase in paper pieces can make a society richer. If that is the case, why is there still poverty in the world? — Hans Hermann-Hoppe
The fiat units can be issued in physical form (notes & coins) and in digital form (commercial banks reserves at the Central Bank).
The total amount of a fiat currency units is called base money or state money.
A money substitute is a claim to a definite amount of money, redeemable on demand.
Lending is the giving of an asset in exchange for another asset that consists of a claim on the 'promise to pay it back' (which is 'debt').
The return of the asset settles the claim.
Giving credit is lending with the connotation of borrower's trust in that promise.
If the borrower is just a custodian, the claim is a special kind of money substitute called money-certificate or representative money.
Reserve ratio = reserved / amount borrowed.
A custodian is the borrower that keeps the full money amount as reserve (reserve ratio = 1). If he does not (reserve ratio < 1), he is practicing fractional reserve, which creates the kind of money substitutes called near-money.
*Image: those are Elvis Presley substitutes or near-Elvis Presleys.
Commercial banks produce money substitutes through the custody and the fractional reserve of the money that is deposited in them; which “multiply” the base money.
-The custody or warehousing service is called safe deposit.
-But the most common service they perform, apart from money transfer, is the fractional reserve: by borrowing money in exchange for claims against those borrowings, reserving a fraction enough to provide liquidity to those claims and investing the rest. Near money usually takes the form of checking accounts (demand deposit) and interest-bearing accounts (time deposit).
Liquidity refers to how easily (time and cost) assets can be converted into proper money.
Reserved (R) = borrowed (B) - invested (I).
Reserve Ratio = R / B. Debt Ratio = B / R (= money multiplier)
Capital Ratio = R / I. Savings Ratio = I / R
Money multiplier = (money substitutes + base money not reserved in banks) / base money
If we assume there is no base money out of banks (cash), then the money multiplier = 1 / average reserve ratio
Alice deposits 100$ in the bank A.
Because bank A does not expect most of its depositors to require a withdrawal from their accounts at the same time, bank A holds 10% of the received deposits as a reserve, and lends the rest.
So bank A keeps 10$ as a reserve and lends 90$ to Bob.
Alice checking account shows she has 100$ available.
Bob uses the loan to buy a bike from Amy.
Amy deposits her 90$ in bank B.
Bank B keeps 9$ and lends 81$ to Henry.
Amy’s checking account shows she has 90$ available.
Henry uses the loan to buy a surfboard from Eva.
Eva deposits her 81$ in bank C.
Bank C keeps 8.1$ and lends 72.9$ to Pankun.
Eva’s checking account shows she has 81$ available.
from the initial 100$ cash from Alice (state money), it have been created 271$ of near-money :
100$ in the Alice’s checking bank account in bank A
90$ in Amy’s checking bank account in bank B
81$ in Eva’s checking bank account in bank C
The initial 100$ cash now are distributed:
10$ in bank A
9$ in bank B
8.1$ in bank C
72.9$ on Pankun’s pocket.
Near money: 100 + 90 + 81 = 271$
Amount reserved in banks from deposits = 10 + 9 + 8.1 = 27.1$
Money: 10 + 9 + 8.1 + 72.9 = 100$
Money multiplier = 271$ + 72.9$ / 100$ = 3.4
If the 72.9$ would have ended up deposited in a bank and the process would have continued while banks maintain an average of 10% as the reserve ratio:
Money multiplier = 1 / 0.10 = 10
Total amount of near-money = 100 * 10 = 1000$.
The banks’ near-money creation process is sometimes called “money creation process”. But, the real money creation process is executed by the Central Bank. The near-money creation process is executed by commercial banks. This is why near-money is also called bank money.
Consumer prices are in close relation to the total amount of bank money while not much related to state money, because retail fiat savings are mostly in the form of bank money.
This recognition led to the study of the money aggregates (M0, M1, M2, M3).
M0 is the state money. M1, M2 and M3 represent claims on base money plus cash; they are calculated aggregating different kind of money substitutes to cash.
Just before the global financial crisis of 2007-2010, the top 30 fiat currencies of the world had an average money multiplier close to 10, that is, the amount of M3 (bank money) was 10 times the M0 (base money). There were around 10 claims of 1$ per $ created.
By 2018, after all the base money printing for rescuing big banks and financial institutions, the money multiplier went down to 5.5. The sum of the top 30 fiat money M0 went from $5 trillion to $20 trillion, but the amount of M3 did not increase at such a high rate.
During the crisis, M3 of some currencies even contracted temporally due to a decreasing in borrowing in such an uncertainty time, leading to a light deflation of consumer prices.
The money multiplier is limited by the need for base money to settle payments.
The main tool to influence that money multiplier, and thus M3, is the manipulation of some interest rates by central bank intervention:
Lower interest rates incentives borrowings to increase, so bank money is created. M3 increases.
Higher interest rates incentives borrowings to decrease, so bank money is destroyed. M3 decreases.
Recommended thread for more info and charts: