Vertical and horizontal components of the money supply

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Vertical and horizontal components of the money
supply

• Professor Bill Mitchell
• Centre of Full Employment and Equity
• University of Newcastle, Australia

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• Aims of this presentation
• To reinforce your understanding of the vertical
  components of the money supply process.
• To distinguish this from the horizontal
  components of the money supply process.
• To relate this distinction to the fundamental
  relations in macroeconomics between the
  Government and Non-government sectors.
• To understand the nature of vertical transactions
  and their relation to the creation of net
  financial assets.

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• Neoclassical monetary theory considers that money
  enters into the economy via exchange.
• The current stock of money is determined by the
  interaction with high powered money issued by the
  Central Bank (CB) and the money multiplier (which
  is a function of the reserve ratio and deposits
  ratio).

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• Thus, the CB controls the money supply (it is
  exogenous).
• Interest rates in this model are endogenous and
  rise if budget deficit spending rises as a result
  of the squeeze on finances in the money market.
• The only way a budget deficit can occur without
  higher interest rates is if the CB increases high
  powered money and that is considered
  inflationary.
• Further, deficits require bond-financing which
  implies that taxes have to be higher in the
  future.

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• The Government is the monopoly provider of fiat
  currency.
• This means that government spending does not
  require financing.
• Taxes are levied (in part) to ensure that the
  private sector has an incentive to transfer goods
  and services to the public sector in response to
  Government spending of fiat currency.

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• The private sector (households and firms,
  including banks) has to acquire the fiat currency
  to pay its taxes.
• If the Government is in deficit, then the surplus
  fiat currency in the private sector is
  accumulated as cash, bank reserves, or as
  Treasury Bonds (deposits offered by the CB).
• The taxes are scrapped (as the CB wipes off
  liabilities from its balance sheet).
• Logically, taxes cannot finance spending because
  fiat currency has to be spent prior to taxes
  being paid.

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• Why are bonds-issued?
• They provide the financial system with an
  interest-bearing asset and allow banks with
  excess reserves an opportunity to earn above a
  zero return.

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• Bond issues are part of monetary policy.
• If the fiscal spending has created excess
  reserves and there is downward pressure on the
  cash rate, then the CB can sell bonds as a means
  of maintaining their cash rate goals.
• Spending adds to reserves while taxes and bond
  sales drain reserves. The latter are considered
  to be part of the CB reserve maintenance
  operations.

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• The vertical components of the money supply
  process include
• the obtaining of fiat currency from the State
• the paying of taxes to the State
• Bond sales.

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• CB policy determines the relative distribution of
  the accumulated currency units of the private
  sector between cash, reserves (clearing
  balances), and Treasury securities.
• State (deficit) spending determines the magnitude
  of those accumulated financial assets.

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• The horizontal component is well-described in
  Post Keynesian monetary theory and includes the
  all credit activities that leverage of the fiat
  currency.
• While the vertical component is exogenous, the
  horizontal component is endogenous and nets to
  zero.

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• The banking system responds to depends for credit
  to finance production and then worries about the
  reserve implications.
• The CB stands ready to lend reserves should the
  banks fall short to maintain stability of the
  system and the current cash rate target.
• Government spending cannot crowd out investment
  in this setting.

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• Summary points
• The Government deficit (surplus) must equal
  dollar-for-dollar the Non-government sector
  surplus (deficit).
• The Government is never financially constrained.
• Budget deficits contribute to the savings of the
  Non-government sector.
• They put downward pressure on interest rates.

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• End of lesson