Estimating Money Supply

This Blog is about the value of the U.S. dollar. It has presented a formula for estimating the value of the dollar that I have not seen elsewhere, and argues that, despite current appearances and conventional wisdom, the value of cash will rise as the recently explosive credit economy collapses.

The cash value equation depends on knowing the supply of money in circulation. There is widespread acknowledgement that in a fractional reserve system money supply is the sum of printed currency and unpaid credit.

The Fed's way of estimating money supply is by adding printed currency and deposits. MO is base money supply, M1 is MO + money in checking accounts, M2 reflects M1 + money in CDs, savings accounts, and money market accounts, and M3 reflects M2 + money in long-term CDs. In this system, deposits are the mirror image of credit: so long as the money the seller receives when a buyer borrows money for an item is then deposited back in the bank.

For example, if Peter takes out a loan from a bank to buy a used car from Paul, and Paul deposits that money in his bank account, then that deposit reflects the car loan. Furthermore, in fractional reserve lending, if 10% reserves must be kept, then 90% of Pauls recent deposit can be lent further from the bank. If that money is then bundled with other deposit accounts to provide the loan for a mortgage, and if the seller of the house deposits the money in a bank account, the outstanding credit for the house can be estimated by the sellers deposit. The assumption is that all money lent by banks to purchase a good eventually is deposited (either directly by the seller or in a roundabout way changing hands first) back into banks. This is probably not a bad assumption.

Customarily, banks lend out money they have in deposits. Over the past few years, banks have used other sources of capital to originate loans. The next few non-news-related posts will reflect ways credit has entered the economy independent of deposit accounts.

ADDENDUM [2/1/09]: Looking back, I need to make a clarification: the Fed stopped publishing M3 in March, 2006, which I knew when I wrote this.