What Is Amortized Money Supply?
Amortized money supply refers to the conceptual process by which the overall money supply within an economy contracts as existing debt is repaid or "amortized." In the field of Monetary Economics, this concept highlights the less frequently discussed aspect of money destruction, complementing the more commonly understood process of money creation. While "Amortized Money Supply" is not a formally defined monetary aggregate like M1 money supply or M2 money supply, it serves as a framework to understand how the repayment of loans reduces the total stock of money in circulation. This phenomenon is particularly relevant in systems where money is largely created by the extension of credit by commercial banks, rather than solely through sovereign issuance.
History and Origin
The conceptual underpinning of "Amortized Money Supply" is deeply intertwined with the theory of endogenous money supply. This theory posits that, in modern economies, the majority of money is created by commercial banks through the act of making loans, rather than being exogenously controlled by a central bank through a "money multiplier" mechanism. Historically, economists debated the origins and control of the money supply. Earlier views often emphasized the central bank's direct control over the monetary base. However, a significant shift in understanding occurred with the rise of endogenous money theory, championed by economists like Basil Moore and others, particularly in the latter half of the 20th century.7
The Bank of England, for instance, has clarified that "money is created by commercial banks making loans."6 When a bank issues a loan, it simultaneously creates a new deposit in the borrower's account, thus increasing the total money supply. Conversely, when a borrower repays a loan, the money is effectively "destroyed" as the deposit balance is reduced and the bank's assets (the loan) and liabilities (the deposit) shrink. This continuous process of money creation through new debt issuance and money destruction through debt repayment (amortization) forms the core of understanding an amortized money supply.
Key Takeaways
- Amortized money supply describes the contraction of the money supply due to the repayment of loans.
- It is a conceptual framework, not a formal monetary aggregate measure.
- In an endogenous money system, loan repayment effectively "destroys" money that was created when the loan was initially granted.
- This process influences overall economic liquidity and can impact economic activity.
- The concept highlights the cyclical nature of money creation and destruction tied to credit cycles.
Interpreting the Amortized Money Supply
Interpreting the concept of an amortized money supply involves recognizing that the aggregate level of money in an economy is not static but constantly fluctuates based on the extension and repayment of credit. When individuals and businesses repay their loans, such as mortgages or business loans, the funds used for repayment effectively disappear from the broader money supply. This reduction contrasts with money creation, which occurs when banks extend new credit.
For instance, if an economy experiences a period of rapid loan repayment without a corresponding increase in new lending, the amortized money supply would indicate a shrinking overall money stock. This dynamic can have implications for economic activity, potentially leading to deflationary pressures if the rate of money destruction through amortization outpaces the rate of new money creation. Understanding this ongoing process is crucial for analyzing macroeconomic trends and the effectiveness of monetary policy.
Hypothetical Example
Consider a simplified economy with a single commercial bank and a total initial money supply of $1,000, consisting entirely of demand deposits.
- Initial State: John Doe has $1,000 in his checking account.
- Loan Creation: The bank grants Jane Smith a $500 business loan. The bank credits Jane's checking account with $500. The money supply temporarily increases to $1,500 ($1,000 for John, $500 for Jane). This new money was created ex nihilo by the bank's lending activity.
- Loan Amortization (Repayment): A month later, Jane repays $50 of her loan, with $45 going towards principal and $5 towards interest rates. Jane uses funds from her demand deposits to make this payment.
- Effect on Money Supply: When Jane repays the $45 principal, that $45 effectively ceases to exist in the broader money supply. The bank's loan asset decreases by $45, and Jane's deposit liability to the bank also decreases by $45. The money supply, therefore, reduces by $45 (not including the interest payment, which is income to the bank and remains within the system as the bank's deposit).
This scenario illustrates how the amortized money supply component, representing the principal repayment, leads to a direct reduction in the money stock, offsetting some of the money created by new lending.
Practical Applications
The concept of an amortized money supply holds practical relevance in understanding various aspects of financial markets and macroeconomic conditions.
- Credit Cycles: It provides insight into the contractionary phase of credit cycles. During economic downturns or periods of deleveraging, accelerated debt repayment or defaults can lead to a significant reduction in the money supply through amortization, exacerbating economic contraction.
- Monetary Policy Effectiveness: A vigorous amortized money supply can diminish the effectiveness of expansionary monetary policy tools, such as quantitative easing or interest rate reductions, if the rate of money destruction through debt repayment outpaces new money creation. Central banks, like the Federal Reserve, track various monetary aggregates (e.g., M2 money supply) to gauge the total money in circulation, which implicitly includes these dynamics.4, 5
- Financial Stability: Understanding how debt amortization affects the money supply helps assess systemic debt levels and potential financial instability. High levels of outstanding debt mean that a significant portion of the money supply could be "amortized" rapidly if repayments accelerate, potentially leading to liquidity shortages.
- Bank Balance Sheets: For financial institutions, loan repayments directly impact their balance sheet. As loans are amortized, the bank's loan assets decrease, and the corresponding deposit liabilities (money in the economy) decrease. This constant flow highlights the bank's role as both a creator and destroyer of money.
Limitations and Criticisms
The primary limitation of "Amortized Money Supply" is that it is not a standard, quantifiable measure tracked by central banks or financial authorities. Unlike formal monetary aggregates such as M1 or M2, which are regularly reported (e.g., by the Federal Reserve in its H.6 release), the "amortized money supply" is a conceptual term used to illustrate a specific aspect of money dynamics.3
Critiques of the underlying endogenous money theory, which forms the basis for this concept, also extend to the idea of an amortized money supply. Some economists argue that while commercial banks create deposits through lending, the central bank still exerts significant control over the overall money supply through its influence on interest rates and the provision of reserves.2 They contend that the central bank's actions ultimately constrain the extent of commercial bank lending and, by extension, the amount of money created and, subsequently, amortized. While proponents of endogenous money argue that reserves are supplied on demand, critics point to factors like reserve requirements (though largely eliminated in many jurisdictions) and capital requirements as constraints on bank lending that limit the "free" creation and destruction of money.1
Amortized Money Supply vs. Endogenous Money Supply
While closely related, "Amortized Money Supply" and "Endogenous Money Supply" describe distinct but interconnected phenomena within monetary economics.
| Feature | Amortized Money Supply | Endogenous Money Supply |
|---|---|---|
| Primary Focus | The destruction or contraction of money | The creation or expansion of money |
| Mechanism | Repayment (amortization) of existing debt | Commercial bank lending and credit extension |
| Direction | Reduces the overall money supply | Increases the overall money supply |
| Nature of Term | A conceptual framework for understanding money contraction via debt repayment | A theory explaining how money is created within the banking system based on economic demand |
The endogenous money supply theory explains how money comes into existence largely through the demand for credit from the private sector and the willingness of banks to lend. When banks make loans, they create new demand deposits, thereby increasing the money supply. The amortized money supply, conversely, refers to the subsequent process where that created money is extinguished as borrowers make principal payments on their loans. Therefore, the amortized money supply is a component of the broader, dynamic process described by the endogenous money theory, specifically focusing on the efflux of money from the system.
FAQs
What does "amortized" mean in a financial context?
In a financial context, "amortized" primarily refers to the process of gradually paying off a debt over time through regular principal and interest rates payments. It can also refer to writing off the cost of an intangible asset over its useful life on a company's balance sheet.
Is Amortized Money Supply a formal economic measure like M1 or M2?
No, "Amortized Money Supply" is not a formal or commonly reported economic measure like the M1 money supply or M2 money supply. It is a conceptual term used to understand how the money supply contracts as loans are repaid.
How does debt repayment affect the money supply?
When debt is repaid to a commercial bank, the principal portion of the repayment effectively "destroys" money. The demand deposits used to make the payment are reduced, and since those deposits constitute part of the money supply, the overall money in circulation decreases.
What is the relationship between amortized money supply and endogenous money theory?
The concept of amortized money supply is a direct consequence of endogenous money supply theory. If money is created when banks issue loans (endogenous creation), then it logically follows that money is destroyed when those loans are repaid (amortization).
Why is understanding amortized money supply important?
Understanding the amortized money supply is important for comprehending the complete dynamics of the money supply, not just its creation. It highlights how factors like deleveraging or reduced borrowing can lead to a contraction in the total money stock, which can influence economic growth and liquidity.