Money, Money Supply,
and Interest

The Concept of Money

Ask what money is and most answers name an object: notes, coins, the balance on a screen. That answer is too narrow and, at the same time, too specific. Cattle have been money. So have salt, cowrie shells, cigarettes in prisoner-of-war camps, and slabs of limestone too heavy to move. None of these have anything physical in common. What they share is a social fact: in some community, at some time, everyone expected everyone else to accept them.

That expectation is the whole of it. Money is not a substance but a role, and almost anything can be recruited into the role provided enough people believe others will play along.

2-1a  Money Defined

The working definition economists use is deliberately behavioural: money is whatever is generally accepted as final payment for goods, services and debts. Two words in that sentence carry the weight.

Generally rules out things accepted in one shop but not the next. An airline's frequent-flyer miles buy a seat on that airline and nothing else; they are a coupon, not money. Final rules out promises that merely postpone payment. A credit card settles nothing at the moment you tap it: the card company pays the merchant, and you now owe the card company. The card is an extremely convenient way of getting at money. It is not itself money.

This is why the boundary is genuinely blurry, and why the official measures in section 2-3 come in more than one size. Cash in your pocket is unambiguously money. A balance in your checking account is money in every practical sense. A three-month certificate of deposit is money-ish: it is yours, but not today. The further you walk along that line, the less "generally accepted, right now, as final payment" the thing becomes.

2-1b  Functions of Money

Rather than test candidates against a definition, it is more useful to ask what work money does. Three jobs, in descending order of importance.

A medium of exchange. This is the job that makes money worth inventing. Without it, trade requires a double coincidence of wants: to eat, the economist must find someone with surplus food who happens to want a lecture on monetary policy. Money breaks the barter problem into two easy halves. Sell your output to whoever wants it, then buy your inputs from whoever has them. Everything about a modern division of labour rests on that.

A unit of account. Prices are quoted in one common measure, so comparisons take one step instead of many. In an economy with 1,000 goods and no money, there are 499,500 separate exchange rates to know. With money there are 1,000 prices. The saving is not a detail; it is the difference between a market that can function and one that cannot.

A store of value. Money carries purchasing power forward in time, letting you sell today and buy next year. It is a mediocre store of value, since inflation erodes it and other assets pay a return while cash does not, but it is unrivalled for being instantly spendable. That is the trade the rest of this chapter is about.

Amount of Money and Money through Time

Having settled what money is, the next question is how much of it there should be. The answer is not "as much as possible", and the reason is the single most reliable finding in monetary economics.

2-2a  The Amount of Money Matters

Money buys goods. Goods are produced by workers and machines, and their quantity is limited by how many workers and machines there are and how good they are. Printing more money does not add a worker or a machine. So if the stock of money doubles while the stock of goods stays put, the only thing that can give is the price of the goods.

Economists write this as the equation of exchange, MV = PY: the money stock times how often each dollar is spent equals the price level times real output. It is an identity, true by construction. It becomes a theory the moment you add the claim that V moves slowly and Y is set by real forces, in which case changes in M land mostly on P.

Now test it. The chart below plots the growth rate of M2 against consumer price inflation, and gives you two dials. The first sets the horizon over which growth is measured: month-to-month, or averaged over five or ten years. The second sets a lag, sliding money growth forward in time before the comparison. Try the combinations before reading on.

The result is the most useful thing in this chapter, and it is not the tidy one. Set the horizon to twelve months with no lag and the scatter is a cloud: over the whole postwar record the correlation between this month's money growth and this month's inflation is close to zero. On that evidence alone you would conclude that money has nothing to do with prices.

Then start turning the dials. Give money a two-year lead and the correlation climbs sharply. Stretch the horizon to five years and it climbs again. At ten-year averages with a two-year lead, the relationship is strong and the slope is not far from one. That is what the quantity theory predicts: over the long haul, an extra percentage point of money growth comes with roughly an extra percentage point of inflation.

That pattern is the finding, and it is worth stating carefully because it is so often stated badly. Money growth is a strong statement about the average rate of inflation over a decade and a nearly useless one about next quarter. Friedman's phrase for the gap was that monetary policy operates with long and variable lags. The dials above are that phrase, made checkable.

Two honest caveats. Correlation at low frequency is not proof of direction, because prices and money can respond to each other and to a third thing. And V is not the constant the simple story needs; the 2010s, when M2 grew steadily and inflation stayed below target, are the standing counterexample. Both facts are visible in the chart if you look for them.

2-2b  Money through Time

The forms money has taken follow a single direction of travel: from things valuable in themselves toward pure record-keeping.

Commodity money is a good that would be worth holding even if nobody used it for payment. Gold, silver, salt and cattle have all served. Its value is anchored by its own usefulness, which limits how badly it can be debased, and by its own scarcity, which limits how fast the money stock can grow. That constraint is both the attraction and the flaw: an economy on a gold standard cannot expand its money supply when it needs to.

Representative money is a claim on a commodity: paper redeemable for a fixed weight of metal. It keeps the anchor while making the money portable. It also introduces the temptation that eventually ends every such system, which is to issue more claims than there is metal.

Fiat money is money by declaration, backed by nothing but the issuing government's word and the public's expectation that others will take it. Every major currency today is fiat. It sounds precarious and is in fact more stable than commodity money in practice, provided the issuing central bank behaves. When it does not, the result is the hyperinflations that make the case for central bank independence better than any argument can.

Bank money, meaning deposits, is where most of the stock now lives. It is not issued by the government at all. It is created by commercial banks in the act of lending, a mechanism taken up in Chapter 7. The chart below makes the scale of this plain: physical currency is a small minority of the money in the economy, and has been for the whole modern record.

Two features of the share series repay attention. It fell for decades as chequing and then card payments spread, which is what you would expect. It then stopped falling and turned up around 2008, which is not. Electronic payment kept spreading, yet cash holdings grew. The usual explanations are a flight to physical currency during financial panics, the very low interest rates that made holding non-interest-bearing cash nearly costless, and foreign demand for dollar notes, a large share of which circulate outside the United States.

2-2c  The Future of Money?

The direction of travel suggests the next step, and several candidates are competing for it.

Cryptocurrencies such as Bitcoin were designed as money and function poorly as it. They are volatile, which disqualifies them as a unit of account; slow and expensive to settle in, which hurts as a medium of exchange; and mostly held in the hope of price appreciation, which is the behaviour of an asset, not of cash. Judge them against the three functions and they fail on two.

Stablecoins pin their value to a currency and are, in structure, representative money for the digital age: a claim on a reserve of dollars. The old question applies unchanged: are the reserves really there, and who checks?

Central bank digital currency would be a direct claim on the central bank held by the public, in effect electronic cash. It would be unambiguously money by any definition. What it would do to commercial banks, which fund themselves with the deposits it would compete against, is the live policy question.

Whatever wins, the three functions in 2-1b are the yardstick. They have outlasted cowrie shells, gold and the gold standard, and they will outlast whatever is currently being announced.

Money Supplies

Because the boundary of "money" is a spectrum rather than a line, statisticians do not report one number. They report a nested family of them, each drawing the line in a different place. Every measure contains the one before it and adds something slightly less spendable.

2-3a  The Old Monetary Aggregates

For most of the postwar period the Federal Reserve published three measures.

M3 was discontinued in 2006, on the reasoning that it cost a great deal to collect and told the Fed nothing that M2 had not already said. The decision remains mildly controversial, mostly among people who would like to check.

2-3b  The New Monetary Aggregates

In May 2020 the definitions changed in a way that matters for anyone reading a chart. A regulation that had capped the number of monthly withdrawals from a savings account was suspended, which made savings deposits effectively chequable. Savings deposits were therefore moved out of the M2-only category and into M1.

M1 stood at under $5 trillion at the time, and the savings deposits arriving from the other side of the line were more than twice that. The result is the near-vertical step you can see in the chart below: M1 more than tripled in a single month without a dollar of new money being created anywhere. M2, which already contained savings deposits, barely registered it.

The lesson generalises well beyond this episode, and is the reason the definitions are worth learning at all. A break in a series is not always an event in the world. Before interpreting any sudden move in official data, check whether the thing being measured changed or the ruler did.

Switch to the logarithmic scale and the chart changes character. On a linear axis, growth in the 1960s looks flat and growth after 2000 looks explosive, purely because the numbers are bigger. On a log axis, equal vertical distances are equal percentage changes, so the slope is the growth rate and eras become comparable. Any series that grows by a percentage each year should be looked at this way at least once.

The Price of Money: Interest Rates

Money, like anything else, has a price. Its price is not what a dollar buys, which is the price level. The price of money is what you pay to have some of it now rather than later, and it is quoted as an interest rate.

There is no single one. There are many, differing by how long the loan runs, how likely the borrower is to repay, and how the interest is taxed. Chapters 3 and 4 take those differences apart. For now, look at how they move.

Three things are visible without any theory. The rates move together, because they are all prices for the same underlying thing. They are ordered, with short and safe below long and less safe, most of the time. And "most of the time" is doing real work: the gaps narrow, and occasionally the order reverses. Those reversals are the subject of Chapter 4 and among the most watched numbers in finance.

2-4a  Time Value of Money

Behind every interest rate is one idea: a dollar today is worth more than a dollar a year from now. Not because of inflation, since this holds even when prices are perfectly stable, but because a dollar today can be put to work, and because certainty beats waiting.

Formalise it and the arithmetic falls out. Lend $100 at 5% and next year you have $105. In two years, $105 grows to $110.25, not $110, because the second year's interest is earned on the first year's interest too. In general the future value of an amount PV after n years at rate r is

FV = PV × (1 + r)^n

Compounding is why small differences in rate turn into large differences in outcome over long horizons, and why the interest rate is the most consequential single number in finance.

One refinement matters before going further. The rate quoted on a loan is nominal. What it earns in purchasing power is real, and the difference is inflation:

real rate ≈ nominal rate − inflation rate

An exact version divides rather than subtracts, (1+i)/(1+π)−1, but the approximation is fine at ordinary rates. The distinction is not academic. A saver earning 4% while prices rise 6% is losing ground, and the chart below shows how routinely that has happened.

2-4b  Present Value

Run the compounding arithmetic backwards and you get the most useful tool in the chapter. If FV = PV × (1+r)^n, then

PV = FV / (1 + r)^n

Present value answers the question every financial decision reduces to: what is a payment I will receive later worth to me now? Bond pricing is present value. Valuing a company is present value. Deciding whether a degree pays for itself is present value. Chapter 3 will price bonds with exactly this formula and nothing else.

The rate you divide by is called the discount rate, and the whole result hinges on it. Because n sits in the exponent, distant payments are punished severely by even modest rates. The calculator below is loaded with the current 10-year Treasury yield; move the slider and watch how quickly the far end of the horizon collapses.

Conclusion

Four things to carry forward.

Money is a role, not a substance. Whatever is generally accepted as final payment is money, which is why the category has held cattle, gold, paper and database entries, and why it is contested at the edges.

The quantity matters, on long horizons. More money chasing an unchanged quantity of goods raises prices. The relationship is strong over decades and loose over quarters, and the scatter above shows both facts at once.

The measures are constructions. M1 and M2 are decisions about where to draw a line through a spectrum, and those decisions get revised. May 2020 is the standing reminder to check the definition before believing the jump.

Interest is the price of time. Compounding runs forward, discounting runs backward, and discounting is the tool. Everything Chapter 3 does to bonds is the present-value formula applied to a schedule of payments.

Data for this chapter

Every series behind the charts above, with a direct link to the FRED page where you can download it.