Sources and Sinks of M1 Money in a Four Sector Model of the U.S. Financial System

Abstract

This paper defines two accounting identities in the Flow of Funds Accounts (FOFA) that specify the level of transaction accounts (demand deposits) in the aggregate Bank balance sheet. The identities are called the Bank generator and the Fed generator (of transaction accounts in M1 money supply). The primary assumption underlying the development of the Fed generator identity is that only the central bank (Fed) can inject transaction accounts into the aggregate Bank which are not injected by the identity defining the Bank generator. A model is introduced to identify the sources and sinks of the M1 money supply in a four sector economy with Treasury, Fed, Banks, and Nonbanks. The model defines a set of abstract symbols linked to flow of funds data which reveal the basic structure of the U.S. financial system. Banks and Fed have the power to create and cancel transaction accounts as a component of the M1 money supply. Nonbanks do not have the power to create or cancel transaction accounts except during specific credit deals made with Fed and Banks. When Fed controls the interbank fed funds lending rate the Treasury must operate like an M1 user to avoid interfering with credit formation of Fed and Banks. Nonbanks can increase the M1 money supply by making withdrawals of currency which are serviced by Fed. Currency withdrawals by Nonbanks do not reduce the aggregate Bank balance sheet when Fed services the currency drain. When Nonbanks change levels of investment in money market mutual funds (MMMFs) this does not create or cancel transaction accounts in the M1 money supply. Nor do changes in the MMMF levels alter the size of the aggregate Bank balance sheet. Instead any change in the levels of MMMF investment simply force the aggregate Bank to adjust its mix of liabilities between deposits and money market instruments.