Thursday, October 13, 2005

Supply of money

The person who on the same day pays an overdue insurance premium, makes the final payment on a bank loan, and pays the final installment on a color TV, is not likely to know which of these transactions reduced the money supply of the United States of America.
-- Schelling. Micromotives and Macrobehavior, 55.

Update: So which of these transactions reduces the money supply? Because I was working backwards, see below, I got the right answer, but for very wrong reasons. Here is, I hope, a more correct explanation. There are several measures of money supply (M1, M2 and M3, for example). According to the Fed:
M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) travelers checks of nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts, and demand deposits at thrift institutions. Seasonally adjusted M1 is constructed by summing currency, travelers checks, demand deposits, and OCDs, each seasonally adjusted separately(emphasis mine).
Loosely, the money supply is money that can be spent. Currency that a bank holds free and clear does count. Making a payment on a bank loan reduces the money supply because the money goes from your hands (or bank account) to the bank. This currency, because it is held by a depository institution (and no one else has a claim on it), does not count in the money supply. So this reduces the money supply. Depending on who you are paying the installment to, a bank or a store, this will reduce the money supply for a similar reason. Since a store is not a depository institution, giving it money does not reduce the money supply. But since the installment plan is probably financed through a bank, same thing holds. And because an insurance company is not a depository institution, this does not reduce the money supply.

My old, and misleading, answer, with qualification:So which one of these reduces the money supply? My tentative answer: paying off the TV reduces the supply of money, because under certain assumptions selling the TV on the installment plan extended credit. Paying it off reduces the supply of credit, which through some mechanism I've forgotten ought to reduce the supply of money. Similarly with the loan. But this is not true of the overdue insurance premium, for no good was gained by having unpaid for insurance. Though this seems rather wrong. Henry?

*It should be noted that I'm sort of working backwards here, for Schelling seems to imply that this is the correct answer, though does not state it explicitely and offers no explanation.


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