Thursday, May 17, 2012

Some money is BOTH base AND broad.

Most people who have worked thru a basic introductory economics text book know that a nation’s stock of money can be split into an infinite number of categories. But one common categorisation involves splitting money supply into just two categories: base and broad.

Base money is central bank created money. Other names include “the monetary base” or “high powered money”. In contrast, there is broad money, i.e. commercial bank created money.

However, there is a small portion of the total money supply which is both base AND broad. This arises where a private sector non-bank entity purchases government debt. And this small portion of the money supply seems to give rise to a large amount of confusion: hence this post.

When a non-bank entity buys government debt, the central bank then owes the entity a debt. But non-bank entities cannot deal direct with central banks. So when the above purchase occurs, the arrangement the relevant parties end up with is: central bank owes a commercial bank a debt, and the commercial bank owes the above entity a debt.

Or as the Bank of England puts it, “When assets are purchased from non-banks . . . the banking sector gains both new reserves at the Bank of England and a corresponding increase in customer deposits.”

And in a different document, and in different words, the BoE says, “If the Bank of England purchases an asset from a non-bank company, it pays for the asset via the seller’s bank. It credits the reserve account of the seller’s bank with the funds, and the bank credits the account of the seller with a deposit. (Hat tip to Gillian Swanson for directing me to the above BoE articles.)

Money is of course a form of debt: a creditor / debtor relationship. And the creditor in that relationship can make someone else the creditor (for some or all of the debt). “Making someone else a creditor” is commonly known as “making a payment”.

The actual size of the above tranche of money that is both base and broad is normally insignificant. But it will have risen substantially as a result of QE. As far as I can see from U.S. figures, the size of this tranche is currently about the same as the total amount of physical cash in circulation ($100 bills, coins, etc).


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