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What causes changes and fluctuations in the volume of money?

John Hermann

A New Zealand colleague recently drew my attention to the NZ Royal Commission into Monetary, Banking and Credit Systems (1956) [1], and in particular to clause 157:

“157. The volume of money (on the Reserve Bank definition) is increased:

  1. When a customer of the Reserve Bank or a trading bank lodges, to the credit of his account, foreign exchange received from the sale of goods or services beyond New Zealand, from gifts or legacies from persons overseas, or from the proceeds of a loan raised with an overseas lender.
  2. When the Reserve Bank or a trading bank buys securities or other assets from an individual or firm and the proceeds are lodged to the credit of the seller’s account at a bank.
  3. When the Reserve Bank makes a loan to the Government or to marketing authorities. At first, the borrower’s deposits at the Reserve Bank are increased, and when this money is spent, the recipients may lodge part of it in their accounts at the trading banks and retain part of it in circulation in the form of notes and coin.
  4. When the customer of a trading bank draws on an overdraft limit granted by the bank and the recipient of his cheque lodges it to the credit of his account at a bank.”

Clause 157 remains valid for modern world economies, however it does not discuss the dynamic nature of the money supply. In particular, bank credit money is temporarily reduced from the money supply M1 whenever a non-bank makes a payment to a bank (including a loan payment, of principal or interest), and bank credit money is temporarily added to M1 whenever a bank spends into the real economy or purchases a financial asset from a non-bank.

In addition to the four modes of money increase listed above, M1 temporarily increases whenever a bank spends or buys assets from non-banks, and when the central government spends into the real economy. And M1 is reduced temporarily when a central government receives tax receipts from non-banks and when it borrows from non-banks.

Moreover, we need to consider deficit spending by a sovereign government, which spending is directly associated with increases in liquid funds available to the private sector, and in particular to non-banks. It will be recalled that liquidity is defined as the conjunction of accessible money and financial assets which are readily convertible into accessible money. Much of the liquidity held by the private sector takes the form of risk-free financial assets, embracing both short-term and long- term Treasury securities. An increase in liquidity has profound economic consequences, contributing to aggregate demand, private sector income and savings, and employment.

So we have a complicated dynamical picture of money and liquidity being created and destroyed, the full import of which may be assessed by setting up a dynamic model of the entire economy, including most importantly the financial and banking sector. Prof Steve Keen’s models attempt to do this, in marked contrast with the economic modelling of mainstream economists.

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