This short paper is the encyclopedia entry on Supply of Money to appear in the second edition of the International Encyclopedia of the Social Sciences. The encyclopedia is edited by William A. Darity and forthcoming from Macmillan Reference USA (Thomson Gale).monetary aggregation; index number theory; Divisia index; encyclopedia entry; aggregation theory; supply of money

Barnett, William A.

English

Research Papers in Economics

 
 
 
Supply of Money 
 
 
 
 
 
William A. Barnett 
University of Kansas 
 
July 14, 2006 
 
 
 
 
 
Abstract:  This short paper is the encyclopedia entry on Supply of Money to appear in the 
second edition of the International Encyclopedia of the Social Sciences.  The encyclopedia is 
edited by William A. Darity and forthcoming from Macmillan Reference USA (Thomson Gale). 
 
Keywords:  monetary aggregation, index number theory, Divisia index, encyclopedia entry, 
aggregation theory, supply of money. 
 
JEL Classifications:  E4, E5, C43, G12 
 
 
 
 
 
 
 
 
 
 
 
 
  1 
1.  Introduction 
  Central bank policy influences the supply of monetary services.  The transmission 
mechanism is not the same in all countries, but commonly the procedure operates through open 
market operations, by which the central bank buys or sells domestic Treasury securities.  Such 
purchases and sales alter the central bank’s balance sheet and thereby “high powered money,” 
also called the monetary base, defined to be the sum of currency and bank reserves.  The 
resulting changes in interest rates and in bank balance sheets alter “inside money,” defined to be 
monetary services produced by banks and other financial intermediaries.  How to measure the 
resulting change in the supplied monetary-service flow in the economy is a complicated matter 
that has been the subject of much debate.  The entry on “Divisia monetary aggregates” in this 
encyclopedia deals with demand-side financial-services aggregation, while this Supply of Money 
entry deals with the supply side. 
  The conventional measurement procedure is to add up the nominal balances of monetary 
assets.  The resulting sum is called the “money supply.”  Subtracting the monetary base from that 
sum produces what is commonly treated as inside money.  Much of the modern literature on 
business cycles revolves around empirical work on the relative effects of inside money and 
outside money.  But the usual measurement of inside money is unrelated to the theory of 
production and the ways in which that theory determines the output services produced by 
financial intermediaries.   
 
2.  High Powered Money 
  During the depression of the 1930s, the monetary base continued to rise in a normal 
manner as the supply of money in the economy collapsed.  Why did this happen?  Currency is 
  2dollar-for-dollar pure money.  But reserves back demand deposits with a multiplier, k.  For every 
dollar removed from demand deposits as the banking system crashed, currency increased by one 
dollar, while reserves declined by 1/k dollars, so that the monetary base changed by 1 - 1/k, 
which is positive.  Hence runs on banks increased the monetary base at the same time that 
demand deposits were declining and banks were failing.  As an instrument or indicator of policy, 
the monetary base is defective, since it adds together currency and reserves, which have very 
different effects on the economy. 
 
3.  Inside Money 
  According to the theory of production, there are two ways to measure the output of a firm.  
One way is to measure the gross value of the output “aggregator function, g.”  The other way is 
to measure the net “value added” by the firm’s production.  By the most conventional and 
simplest accounting convention, called “double deflation,” value added subtracts from aggregate 
output the aggregate over intermediate factor inputs.  Value added then depends only upon 
primary inputs, such as capital, land, and labor.  In the obsolete labor theory of value, only the 
one labor factor was needed, since inputs were assumed to be employed in fixed proportions. 
  Consider the case of a bank that produces a vector of n monetary-asset balances, 
, during period t and pays on those assets the nominal interest rates 
, by employing the vectors of primary inputs, x1t, and intermediate inputs, 
x2t.  If the bank’s technology is described by the production function, f, with outputs separable 
from inputs, we can write g(mt) = f(x1t,x2t), where the value of the output aggregator function is 
Mt = g(mt).  For the most general procedure to measure value added in banking, see Barnett 
(2000, pp. 92 - 93).   
12   = ( ,  , ... ,  ) tt tn mm m′ m t
12   = ( ,  , ... ,  ) tt tn t rr r′ r
  3  The special case of double deflation accounting requires two further assumptions.  The first 
is the existence of aggregator functions, f1 and f2, over primary and intermediate inputs, so that 
Mt = g(mt) = f(f1(x1t), f2(x2t)).  The second is strong separability between primary and 
intermediary inputs, so that Mt = g(mt) = f1(x1t) + f2(x2t).  Value added then becomes f1(x1t) = 
g(mt) - f2(x2t). 
  Under those assumptions, production theory tells us that the supply of inside money 
produced by a bank can be measured by, Mt = g(mt), while value added in banking is f1(x1t) = 
g(mt) - f2(x2t).  Neither theoretical concept has any known relationship with the simple sum 
monetary aggregate,  , provided by most central banks, or with inside money, as measured 
by the simple sum monetary aggregate minus the monetary base.  In contrast, it has been shown 
in Barnett (2000) that total inside money services, Mt = g(mt), can be measured from the Divisia 
index over mt, and that value added in banking, g(mt) - f2(x2t), can be measured by subtracting 
from Mt the Divisia index over x2t. 
1
n
it
i
m
=
∑
 
4.  The Divisia Index 
  The Divisia index is defined in this encyclopedia in its entry for “Divisia Monetary Index.”  
As explained there, user-cost prices must be used within the formula, since monetary assets are 
durable.  So long as required reserves do not exist, the formula for the user-cost price of a 
monetary-asset supplied is the same as the formula for the user-cost price of a monetary-asset 
demanded.  That formula is 
 
ti t
it
t
R r
1R
π
−
=
+
, 
where the benchmark asset rate of return, Rt, on the supply side of money markets, is the rate of 
  4return on loans by the financial intermediary.  But if noninterest-bearing required reserves exist, 
there is a regulatory wedge, requiring subtraction of the implicit tax on banks out of the formula.  
As shown in (2000, p. 57), the corrected user cost price becomes 
 
(1 ) it i t
it
t
kR r
1R
π
−−
=
+
, 
where ki is the required reserve ratio on monetary asset i.   
 
5.  The Economic Stock of Money 
  The Divisia demand-side index and the Divisia supply-side index both measure flows.  
Since the transmission mechanism of money is sometimes viewed as operating through a wealth 
effect, it is useful to know how to discount the present value of the service flow to find the 
economic capital stock of money.  Because of the dependency of that capital stock on future 
expectations, measurement of that capital stock is one of the most challenging areas of this field 
of research.  Since money is now a joint product producing both monetary services and 
investment yield, wealth effects must untangle the discounted present value of the monetary 
services flow from the discounted present value of the investment yield.  See, e.g., Barnett, 
Keating, and Chae (2006). 
 
6.  Conclusion 
  There is reason to be concerned about conclusions regarding policy reached using 
conventional monetary aggregates and conventional measures of inside versus outside money.  
The data provided by many central banks is unrelated to the relevant economic theory, unless all 
financial assets are perfect substitutes.  With different interest rates being paid on different 
  5monetary assets, that implied assumption has been unreasonable for over a half century. 
  Although little research has been done using the relevant theory to measure aggregate 
money on the supply side, a few such empirical studies have been published and reprinted in 
Barnett and Binner (2004, chapters 15 and 16, pp. 351-434).  Also see Barnett, Hinich, and 
Weber (1986). 
 
BIBLIOGRAPHY 
Barnett, William A. 2000. The Microeconomic Theory of Monetary Aggregation.  In Barnett, 
William A. and Apostolos Serletis, eds. The Theory of Monetary Aggregation, 49-99. 
Amsterdam: North Holland. 
 
Barnett, William A, Chae, Unja, and John Keating.  2006.  The Discounted Economic Stock of 
Money with VAR Forecasting.  Annals of Finance 2(2): 229 - 258. 
 
Barnett, William A., Hinich, Melvin J., and Warren E. Weber. 1986. The Regulatory Wedge 
between the Demand-Side and Supply-Side Aggregation-Theoretic Monetary Aggregates.  
Journal of Econometrics 33: 165-185.  Reprinted in Barnett, William A. and Apostolos Serletis, 
eds. 2000. The Theory of Monetary Aggregation, 433 - 453. Amsterdam: North Holland. 
 
Barnett, William A. and Apostolos Serletis, eds. 2000. The Theory of Monetary Aggregation. 
Amsterdam: North Holland. 
 
    William A. Barnett 
  6    Oswald Distinguished Professor of Macroeconomics 
    University of Kansas 
 
 
  7

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