This blog post examines the impact of accurately measuring and controlling the money supply on economic stability, explaining the importance and complexity of monetary policy.
If the money supply—meaning the total amount of money—becomes excessively large or small, it can lead to significant price fluctuations and also affect unemployment rates and interest rates. Therefore, the importance of monetary policy—which involves measuring the money supply and adjusting it to an appropriate level—is growing. However, accurately measuring the money supply is not straightforward. This is because it includes not only cash but also financial instruments with liquidity that can be converted into cash.
Let’s examine why measuring the money supply is difficult by looking more closely at the process of money creation. Money is created when the central bank issues currency and supplies it to economic agents such as individuals and businesses. The currency issued by the central bank is called base money. Some of this circulates as cash, while the rest is deposited in banks. Deposits are money entrusted by economic agents to financial institutions; they possess liquidity that can be converted into cash upon demand and are thus included in the money supply. However, only a portion of these deposits is retained as reserve deposits to cover depositors’ withdrawals; the remainder is lent out. When a portion of deposits is loaned out, an equivalent amount of new money is created, a process called credit creation. For example, when a 10,000 won deposit is loaned out, the original 10,000 won deposit remains in the money supply, while the newly loaned 10,000 won is added to it. This credit creation process repeats, forming a money supply several times larger than the original base money. The increase multiple is called the money multiplier. However, when cash circulating in the economy is deposited into a bank, the amount of cash in circulation decreases by the amount deposited, so the money supply remains unchanged.
As such, the degree of liquidity varies among financial institutions’ products, making it difficult to treat them all as identical currency and complicating the measurement of the money supply. Consequently, central banks in various countries have developed diverse monetary indicators to measure the money supply. For example, Korea’s monetary indicators are divided into two categories starting from 2003. Prior to 2003, the indicators used were ‘currency’, ‘total currency’, and ‘total liquidity’. ‘Currency’ and ‘total currency’ included cash and financial products of deposit banks, while ‘total liquidity’ additionally included financial products of non-bank financial institutions. Non-bank financial institutions are financial institutions excluding the central bank and deposit banks. After 2003, following the IMF’s Monetary and Financial Statistics Manual, the indicators ‘narrow money’, ‘broad money’, and ‘Lf (financial institution liquidity)’ were used. Narrow money includes not only cash but also demand deposits and savings deposits with flexible withdrawal terms held at all financial institutions that handle deposits. Demand deposits and savings deposits with flexible withdrawal terms can be converted to cash immediately upon customer request, making them highly liquid. Therefore, they were grouped together with cash in the same indicator. Broad money adds to narrow money all deposit products offered by financial institutions that handle deposits, including those with low liquidity that require forfeiting interest income to liquidate. This includes financial products with maturities under two years, such as time deposits. However, savings deposits with maturities of two years or more, which were previously included in the ‘total money supply’ indicator, have been excluded due to their very low liquidity. Lf encompasses all financial products from all financial institutions, including savings deposits with maturities of two years or more, which were not included in broad money.
Broad money is generally recognized as the indicator that best reflects the money supply in circulation, and the money multiplier is also based on broad money. Narrow money is more suitable for gauging the size of the short-term financial market, while Lf is more appropriate for assessing the scale of the real economy. Thus, these monetary indicators enable a multi-layered understanding of the money supply, contributing to the efficient operation of monetary policy.
