Transcript The essentials of T

Vertical and horizontal
components of the money supply
Professor Bill Mitchell
Centre of Full Employment and Equity
University of Newcastle, Australia
• 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.
• 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).
• 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.
• 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.
• 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.
 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.
 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.
• 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.
• 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.
• The horizontal component is welldescribed 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.
• 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.
• 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.
End of lesson