What money is: base, broad, and the velocity equation

Money is defined functionally — by what it does, not by what it is made of. Three functions are conventional:

• Medium of exchange. Accepted in trade, so that buying does not require finding someone who simultaneously wants what you sell.
• Unit of account. Prices are quoted in it, accounts are kept in it.
• Store of value. Holding it preserves purchasing power across time, at least over short horizons.

A functional definition implies that money is whatever, in a given economy, fills these roles for most transactions. In modern economies that is a tiered system: central-bank-issued currency at the base, commercial-bank deposits layered on top, and various near-money instruments (money market funds, certificates of deposit) further out. Older systems used commodity money (gold, silver, sometimes salt or shells) where the functional role was filled by a physical substance.

The rest of this lesson distinguishes the tiers, traces how each level is created, and connects the resulting aggregates to the macroeconomic variables that will appear throughout the cursus.

Two aggregates anchor the discussion.

Base money (M0, monetary base, MB). Currency in circulation plus commercial bank reserves held at the central bank. This is the money the central bank directly creates and can directly contract; it appears as a liability on the central bank's balance sheet.

Broad money (M1, M2, M3 — definitions vary by country). Currency in circulation plus various categories of commercial-bank deposits:

• M1 — typically currency plus demand deposits (checking accounts).
• M2 — M1 plus savings deposits and small time deposits.
• M3 — M2 plus large time deposits, institutional money market funds, and other less-liquid items.

The key structural fact: M2 in most modern economies is roughly 5–10 times M0. Commercial banks create most of the money used in the economy by extending loans, not by lending out deposits already at the bank. When a bank makes a loan, it simultaneously creates a deposit equal to the loan principal — a new liability on the bank's balance sheet matched by a new asset (the loan). This is the endogenous-money view that has displaced the older 'money multiplier' textbook model in most modern central-bank explainers.

Base money sits at the bottom; loan-deposit creation by commercial banks layers broad money on top.

Many textbooks describe the banking system through a money multiplier: a bank receives reserves $R$, holds a fraction $r$ as required reserves, lends out the rest, the borrower deposits the loan at another bank, and the process iterates to a total broad money of $R/r$.

This model implies that the central bank chooses reserves and the multiplier produces deposits. Reality runs the other direction:

• A commercial bank decides to extend a loan based on the creditworthiness of the borrower and the bank's own capital and liquidity constraints, not on its reserves.
• The loan creates a deposit immediately, on the bank's own balance sheet. No prior deposit was 'lent out.'
• If the bank's reserves are insufficient for regulatory ratios after the loan, the bank borrows reserves on the interbank market, possibly from the central bank itself.
• The central bank accommodates the reserve demand at its chosen policy rate (or lets the rate move if it does not).

The operational consequence: in a system with abundant reserves (true of most major economies post-2008), the multiplier is not a useful constraint on broad money. Broad money expands when bank loans expand, which depends on credit demand, bank capital, and bank willingness to lend — not on reserves.

This matters for interpreting events like QE, where the central bank greatly expanded base money without a proportional expansion of broad money.

The simplest macroeconomic identity linking money and prices is the quantity equation:

$M \cdot V = P \cdot Q$

where $M$ is the money supply, $V$ is the velocity of money (number of times each unit changes hands per period), $P$ is the price level, and $Q$ is the volume of real transactions (often substituted with real GDP).

As written, this is a tautology: $V$ is defined to make the equation hold. Its content comes from assumptions about which variables are stable and which move.

• If $V$ and $Q$ were both constant, $M$ and $P$ would move together one-for-one. This is the strong quantity theory of money.
• In reality, $V$ moves with interest rates, payment technology, financial structure, and confidence. $Q$ moves with the business cycle, productivity, and demographics.
• Over short horizons (years), $V$ can move substantially — by 20–30% over a few years in major economies. Over long horizons (decades), $V$'s movements are more contained but not zero.

The equation is useful as a bookkeeping discipline. It is not a forecast: predicting inflation from money supply alone fails empirically over decades. The lesson on inflation explores why.

Velocity is the variable that absorbs much of the apparent disconnect between money supply and prices. Three structural drivers move it.

• Payment technology. When payments are slow (paper checks, cash), each dollar must sit longer between transactions, so $V$ is lower. When payments are instantaneous (electronic, cards, real-time settlement), $V$ rises. The transition from cash to digital payments over decades has pushed $V$ up in most economies.
• Interest rates. Higher interest rates raise the opportunity cost of holding non-interest-bearing money. Holders shift toward shorter cash balances and longer interest-bearing assets, raising $V$.
• Confidence and uncertainty. During financial stress, holders prefer holding cash and reserves rather than spending or lending. $V$ falls — sometimes sharply. The 2008–2009 and 2020 episodes both showed multi-year drops in $V$ that absorbed substantial M2 growth without proportional inflation.

The consequence: a central bank that increases $M$ does not mechanically produce a proportional move in $P$. The propagation runs through $V$, $Q$, expectations, and the broader transmission mechanism the next lessons explore.

Two structural categories of monetary systems matter for understanding modern macro.

Commodity money. A monetary base anchored to a physical substance (historically gold or silver). The central bank's currency is convertible to the commodity at a fixed rate. Constraints: the money supply is bounded by the available stock of the commodity, which limits monetary policy flexibility. International settlement and current account adjustment happen through gold flows, with consequences for prices and employment.

Fiat money. The currency is not convertible to any commodity at a fixed rate. Its value derives from legal tender status, tax acceptance, and the willingness of the population to hold and use it. The central bank can expand or contract the base at will, subject only to the inflation and exchange-rate consequences.

All major modern economies use fiat money. The Bretton Woods system (1944–1971) was a hybrid: domestic currencies were not directly convertible to gold for most holders, but the US dollar was convertible at $35 per ounce for foreign central banks, and other currencies were pegged to the dollar. The system ended in 1971 when the US suspended convertibility.

Fiat money is more flexible and more reliant on institutional credibility. The history of the post-1971 system is in substantial part the history of central banks building and maintaining that credibility through inflation-targeting frameworks, central-bank independence arrangements, and operational discipline.

The framework established here will be used throughout the cursus.

• Base vs broad money lets the next lessons distinguish what the central bank directly controls (base) from what most matters for spending and lending (broad). Tools like QE primarily affect base; the transmission to broad money is indirect and goes through bank lending and credit demand.
• The quantity equation provides bookkeeping discipline: any claim about money and prices must respect $MV = PQ$ as an identity, with the substantive content in claims about which variables move and which are stable.
• Velocity is the variable that absorbs gaps between money supply and prices, especially over short horizons. Recognizing $V$ as endogenous is what separates 'money supply causes inflation' from 'money supply is one of several factors influencing inflation through specific transmission channels.'
• Fiat vs commodity clarifies why central-bank credibility and institutional design are themselves macroeconomic variables. In a fiat system, the expected behavior of the central bank shapes outcomes more than its current actions.

The next lesson moves from the supply side (money) to the price side (inflation), examining how the latter is measured, what drives it, and why expectations about future inflation are themselves a primary input.