An excess or shortage of money can have a significant impact on inflation, unemployment, interest rates, and more. Accurately measuring and appropriately adjusting monetary policy is essential for economic stability. However, accurately measuring money supply is challenging due to differences in the liquidity of different financial instruments.
Too much or too little money, which is the total amount of money in circulation, can lead to price fluctuations and affect unemployment and interest rates. As a result, it is increasingly important for monetary policy to keep track of money supply and adjust it to the right level. However, it’s not easy to accurately measure money supply. This is because money includes not only cash, but also financial instruments with liquidity that can be converted into cash.
Let’s take a closer look at the process of currency formation to understand why it’s difficult to determine the amount of money. Currency is created by central banks that print money and supply it to economic agents, such as individuals and businesses. The money issued by the central bank is called base money, and some of it is circulated as cash, while the rest is deposited in banks. Deposits are money that economic agents leave with a financial institution and are therefore included in the currency because they are liquid and can be converted into cash on demand. However, only a portion of these deposits are kept as reserves to cover depositors’ withdrawals, while the rest are lent out. When a portion of the deposits are lent out, new currency is created equal to the amount of the loan, which is called credit creation. For example, when a bank lends out 10,000 won deposited in a bank, the deposit of 10,000 won is still included in the money supply, but the loan of 10,000 won is added to the money supply. As this process of credit creation is repeated, the amount of money is many times larger than the original currency, and the multiplier of the increase is called the currency multiplier. However, when cash in circulation is deposited in a bank, the amount of cash in circulation decreases by the amount of the deposit, so there is no change in the amount of money.
As such, it is difficult to treat all financial instruments of financial institutions as the same currency because they have different degrees of liquidity, which complicates the measurement of the amount of money. In response, central banks in each country have created various monetary indicators to measure the amount of money. Korea’s currency indicators have been bifurcated since 2003. Prior to 2003, Korea’s monetary indicators were ‘currency’, ‘total currency’, and ‘total liquidity’. ‘Currency’ and ‘total currency’ included cash and financial instruments of depository banks, while ‘total liquidity’ added financial instruments of non-bank financial institutions. Non-bank financial institutions are financial institutions other than central banks and depository banks. From 2003 onwards, the indicators ‘consultation money’, ‘broad money’ and ‘Lf (liquidity of financial institutions)’ are used, in accordance with the IMF’s Monetary and Financial Statistics Manual. Consultative money includes not only cash but also demand deposits and time and savings deposits at all deposit-taking financial institutions. Demand deposits and time deposits are included in the same metric as cash because they are highly liquid and can be converted to cash immediately upon customer demand. Broad money adds deposit instruments from any financial institution that accepts deposits in a fiat currency, including those that are less liquid because they can only be cashed out by giving up interest income. This includes financial instruments with maturities of less than two years, such as time deposits. However, savings deposits with maturities of two years or more, which were included in “total money” in the previous indicator, are excluded due to their very low liquidity. Lf covers financial instruments of all financial institutions that are not included in broad money, such as savings deposits with maturities of two years or more.
Broad money is generally recognized as the best proxy for the amount of money in the market, and the currency multiplier is based on broad money. While the broad money is better suited to capture the size of the short-term financial market, the Lf is better suited to capture the size of the real economy. These monetary indicators provide a multi-layered view of money supply, which can contribute to efficient monetary policy management.
