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What is money?

  • Writer: Macroprudential Policy
    Macroprudential Policy
  • Aug 6, 2020
  • 4 min read

Updated: Aug 12


Cash withdrawal machine

Statistical evidence shows that over 90% of broad money in the U.S. exists as bank deposits, while the velocity of M2 has fallen to historic lows, reflecting the growing role of near-money instruments.


Modern monetary systems are fundamentally debt-based. Banks create money by issuing loans, simultaneously creating matching deposits, which form the majority of money supply.

Governments, corporations, and households also issue debt in the form of treasuries, bonds, and mortgages, which can function as near-money when markets are liquid and interest rate volatility is low.

Traditional money supply definitions (M1, M2, MZM) often fail to capture this dynamic because securitization and shadow banking transform deposits into marketable securities. This blurs the line between money and non-money and weakens the historical link between money aggregates and GDP or inflation.


All Forms of Money Are Debt


Modern monetary systems are fundamentally debt-based. This principle has remained true despite the evolution of money from private banknotes to centralized currencies. Understanding that all forms of money are debt is crucial for analyzing financial stability, monetary policy, and the relationship between money and economic activity.


The Debt Nature of Money


Historically, before the rise of central banks, private banks issued notes with no maturity, functioning as promises to pay on demand (Gorton, 2012). These notes were essentially liabilities of the issuing banks. When central banks standardized notes, the mechanism of money creation did not fundamentally change:

  • Banks create money by issuing loans.

  • Each loan debit is matched by a deposit credit in the borrower’s account.


Hence, every unit of new bank money is a liability. According to the Bank for International Settlements (BIS, 2015), more than 90% of broad money in advanced economies exists as commercial bank deposits created through lending.


Debt creation is not confined to banks. Governments, corporations, and households also issue debt:

  • Governments issue treasuries.

  • Corporations issue bonds or commercial paper.

  • Households issue mortgages and personal loans.


Unlike bank deposits, these securities do not automatically create matching deposits because they are direct liabilities of the issuers. Nevertheless, in highly liquid financial markets, treasuries and corporate bonds behave increasingly like money, because investors can convert them into cash quickly.


Deposits vs. Securities: A Liquidity Spectrum


The key difference between a deposit and a security lies in liquidity and price certainty:

  • Deposits can be withdrawn at par, on demand.

  • Securities can generally be sold quickly in liquid markets, but their market price may fluctuate.


In low-interest rate environments, the risk of capital loss is minimal, and securities start functioning as “quasi-money.” For example, during 2020–2021, U.S. Treasury yields hovered near 0.5%–1%, and short-term Treasuries exhibited historically low volatility (U.S. Treasury, 2021). Consequently, investors could treat Treasuries almost like large-value deposits.

This liquidity-based definition aligns with Keynes’ liquidity preference theory, suggesting that the line between “money” and “near-money” instruments becomes blurred during periods of financial stability.


Money Supply Definitions and Limitations


Central banks define money supply in layers. In the U.S.:

  • M1: Currency in circulation + checkable deposits

  • M2: M1 + savings deposits + small time deposits (<$100,000)

  • MZM (Money Zero Maturity): M2 – time deposits + institutional money market funds

(Federal Reserve, 2023)


However, these static definitions struggle to capture financial innovation:

  1. Securitization transforms deposits into marketable securities.

    • When banks securitize loans and sell them to nonbanks, deposits leave the banking system, reducing measured money supply.

  2. Bonds can act like money in low-volatility markets.

    • If Treasury or AAA corporate bond prices fluctuate minimally, they function as deposit substitutes, despite being classified as “non-money.”


This explains why the historical correlation between money aggregates and GDP growth or inflation has weakened. The Federal Reserve acknowledges that since the 1980s, velocity of money (GDP/M2) has steadily declined, reflecting the growing role of near-money instruments (Federal Reserve Bank of St. Louis, 2022).


Statistical Evidence


  • In the U.S., bank deposits account for ~91% of M2, confirming that bank debt is the dominant form of money (Federal Reserve, 2023).

  • M2 velocity fell from 1.8 in 1981 to 1.1 in 2019, and further to ~1.0 in 2022, highlighting the disconnect between money aggregates and economic activity (FRED, 2022).

  • The shadow banking sector, which issues securities functioning as money, grew to over $200 trillion globally by 2022, complicating the traditional money supply measurement (FSB, 2022).


Conclusion


All money is ultimately debt, whether in the form of bank deposits, treasuries, or highly liquid securities. The distinction between money and non-money has blurred as financial markets evolved, interest rates declined, and securitization expanded. Consequently, traditional money supply metrics (M1, M2) have become less predictive of GDP and inflation, pushing economists and policymakers to focus more on liquidity conditions and credit creation rather than static aggregates.


References


  • Bank for International Settlements (BIS). (2015). Money Creation in the Modern Economy. BIS Quarterly Review.

  • Federal Reserve. (2023). H.6 Money Stock Measures. Board of Governors of the Federal Reserve System.

  • Federal Reserve Bank of St. Louis (FRED). (2022). Velocity of M2 Money Stock (M2V).

  • Financial Stability Board (FSB). (2022). Global Monitoring Report on Non-Bank Financial Intermediation.

  • Gorton, G. (2012). Misunderstanding Financial Crises: Why We Don’t See Them Coming. Oxford University Press.

  • U.S. Treasury. (2021). Daily Treasury Yield Curve Rates.

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