Damon Mcknight
The Austrian School of Economics, founded by Ludwig von Mises, has a unique perspective on the concept of the money supply, which is vital for understanding inflation and business cycles. Mises' Theory of Money and Credit defines money as the medium of exchange for goods and services. However, the Austrian School has not provided a comprehensive definition of the money supply, leading to ambiguity. The money supply, or money stock, is the total amount of money available in an economy at a given time, with increases causing inflation and decreases causing deflation. The Austrian view emphasizes the subjective value of assets, including demand deposits, in the market.
| Characteristics | Values |
|---|---|
| Money supply or money stock | The total amount of money available in an economy at a particular point in time |
| Increase in money supply | Inflation |
| Decrease in money supply | Deflation |
| M0 or "narrow money" | Notes and coin in circulation outside the Bank of England, and banks' operational deposits with the Bank of England |
| M1 | Currency in circulation plus overnight deposits |
| M2 | M1 + deposits with an agreed maturity of up to and including two years + deposits redeemable at notice of up to and including three months |
| M3 | M2 + repurchase agreements, money market fund shares and units, as well as debt securities with a maturity of up to and including two years |
| MZM ("money, zero maturity") | M2 – small-denomination time deposits + institutional money market mutual funds |
| Money supply M2 in Austria as of April 2020 | Almost 12.9 trillion euros |
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What You'll Learn
The role of demand deposits
Demand deposits are an important part of the money supply of a country. They are defined within M1 money, which consists of currency plus demand deposits. M1, or narrow money, is often synonymous with the money supply in financial media reports. Demand deposits are funds in a bank account that can be withdrawn on demand at any time. They are typically used to pay for everyday expenses and are important in consumer spending. Examples of demand deposits include amounts in a checking or savings account.
In Austrian economics, the inclusion of demand deposits in the money supply has been a subject of debate. Ludwig von Mises, the developer of the Austrian theory of money, argued for including demand deposits as part of the money supply "in the broader sense." He pointed out that bank demand deposits were not other goods and services but were instead redeemable for cash at par on demand. However, during a run on the bank, demand deposits may no longer function as part of the money supply, especially not at par.
The treatment of demand deposits as part of the money supply also depends on the banking system in place. In fractional reserve banking, demand deposits may not be truly redeemable at par on demand, leading to the argument that only standard cash should be considered part of the money supply. On the other hand, in 100% reserve banking, demand deposits are fully redeemable in cash and function as genuine warehouse receipts to money.
The inclusion of demand deposits in the money supply is significant because it affects the overall money supply of a country. Demand deposits make up a significant portion of the money supply in many countries. During a financial crisis, large withdrawals from banks can lead to a decline in demand deposits and a decrease in the money supply, impacting the amount of money available for loans.
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Mises' Theory of Money and Credit
Ludwig von Mises' 1912 book, 'The Theory of Money and Credit', is considered one of the most influential and controversial treatises on monetary theory. It is a foundational work of the Austrian School of economic thought, which holds that the economy functions best without government intervention in the money supply. Mises' work was the first successful integration of microeconomics and macroeconomics, offering new insights into the origin, nature, value, and future of money.
Mises' theory of the origins of money is based on his regression theorem, which is supported by step-by-step logical argument. He argues that money originated in the market and that its value is based on its usefulness as a commodity in exchange. This challenges the mainstream Quantity Theory of Money (QTM), which posits a direct relationship between prices and the money supply. Mises critiques QTM for being overly simplistic and mechanistic, neglecting the subjective evaluations of market participants. His regression theorem posits that the purchasing power of money today is linked to its value yesterday, creating a continuous regression to the point when money was first introduced.
'The Theory of Money and Credit' also includes Mises' early blueprint for a return to a fully-backed gold standard and competitive banking. Mises believed in the importance of sound money with no inflation, and that the great inflations of the 20th century were man-made, specifically caused by governments. He advocated for a radical shift away from statism and towards a private property order.
The book has received high praise from economists such as Murray Rothbard, who called it "the best book on money ever written," and Sandeep Jaitly, who described Mises as "the greatest economist of the twentieth century." Mises' work continues to inspire politicians and market experts, influencing economic policies and sparking debates about the role of the state in the economy.
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Inflation and deflation
Money supply, or money stock, is the total amount of money available in an economy at a particular point in time. An increase in the money supply is called inflation, while a decrease is called deflation. Inflation and deflation are important concepts in Austrian economics, which emphasises the central importance of subjective estimates of importance and value in the market.
Inflation refers to a general increase in prices for goods and services in an economy, which corresponds to a decrease in the purchasing power of money. Inflation can be measured in various ways, including the Consumer Price Index (CPI) and the Producer Price Index (PPI). During inflation, demand deposits can still function as part of the money supply.
Deflation, on the other hand, refers to a general decrease in prices for goods and services, leading to an increase in the purchasing power of money. Deflation can occur during a recession when supply exceeds demand, causing prices to fall. In a state of deflation, a bank's demand deposits may no longer function as part of the money supply.
In the context of Austrian economics, Ludwig von Mises's "The Theory of Money and Credit" provides guidelines for understanding the money supply. Mises defines money as the general medium of exchange, the thing that all other goods and services are traded for, and the final payment for such goods on the market. However, questions remain about the inclusion of certain financial instruments, such as savings deposits, in the definition of the money supply.
The Austrian School of economics recognises various monetary aggregates to measure and interpret the money supply, including M0 ("narrow money"), M1 ("currency in circulation plus overnight deposits"), and M2 ("intermediate money"). These aggregates help economists understand the relationship between the money supply and economic phenomena such as inflation and business cycles.
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Monetary aggregates
In the US, monetary aggregates are labelled as M0, M1, M2, and M3, and are used by the Federal Reserve to implement its monetary policy. M0, or the monetary base, is the total supply of currency in circulation, plus the stored portion of commercial bank reserves within the central bank. It is not widely observed and differs from the money supply, but it is important as it can be multiplied through the process of fractional reserve banking, becoming high-powered money (HPM). M1 includes M0, plus non-bank travellers' cheques and checkable deposits. M2 includes money market shares, overnight repurchase agreements, and general-purpose fund balances, broke money market, saving deposits, plus M1. M3 includes large deposits of over $100,000, agreements, balance in money market funds, and Eurodollar deposits, plus M2.
The Federal Reserve uses monetary aggregates to evaluate the economic health and stability of the nation, and as a metric for how its open-market operations affect the economy. Monetary aggregates are also studied by investors and economists to predict the Federal Reserve's next actions, such as raising or lowering interest rates.
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M1 and M2 definitions
In Austrian economics, Ludwig von Mises set forth the essentials of the concept of the money supply in his "Theory of Money and Credit". However, no Austrian has developed the concept since, and questions remain, such as whether savings deposits should be included in the money supply.
In macroeconomics, money supply (or money stock) refers to the total volume of money held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circulation (i.e. physical cash) and demand deposits (depositors' easily accessed assets on the books of financial institutions). Money supply data is recorded and published by the national statistical agency or the central bank of the country.
Empirical money supply measures are usually named M1, M2, M3, etc., according to how wide a definition of money they embrace. The precise definitions vary from country to country, depending on national financial institutional traditions. Even for narrow aggregates like M1, the largest part of the money supply consists of deposits in commercial banks, while currency (banknotes and coins) issued by central banks makes up a small part of the total money supply in modern economies.
M1 consists of money commonly used for payment, basically currency in circulation, and checking account balances. It includes cash currency in circulation, plus deposit money, and is measured daily by the Federal Reserve System. Traveler's checks are also included in M1, but their use has decreased over the years.
M2 is a broader classification of money than M1. It includes M1 and "close substitutes" for M1. M2 is a more comprehensive calculation than M1 because it includes highly liquid assets not intended for routine use as cash. M2 includes everything in M1 but also adds other types of deposits. For example, M2 includes savings deposits in banks, which are bank accounts that do not allow for writing a check directly but allow for easy withdrawal of money at an automatic teller machine or bank. M2 also includes money market funds and certificates of deposit.
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Frequently asked questions
Money supply, or money stock, is the total amount of money available in an economy at a particular point in time. An increase in the money supply is called inflation, while a decrease is called deflation.
M1 is defined as currency in circulation plus overnight deposits. M2, or "intermediate money", is the sum of M1, deposits with a maturity of up to two years, and deposits redeemable at a maximum notice of three months.
The Austrian theory of money was developed by Ludwig von Mises in his 1912 book, *The Theory of Money and Credit*. In it, Mises argues that money is the general medium of exchange and that demand deposits should be included in the money supply because they are redeemable for cash on demand.
