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Vertical and Horizontal components of the Money Supply

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 rise as a result of the squeeze 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.

In this brief, we show 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 Government is the monopoly provider 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 (either the cash is burned or 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.

These are termed vertical components and include the obtaining of fiat currency from the State, the paying of taxes to the State, or any intermediation in the process. 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 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. 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.

The diagram below summarises this discussion.