Money supply

Money supply ("monetary aggregates", "money stock"), a macroeconomic concept, is the quantity of money available within the economy to purchase goods, services, and securities.

Introduction

The monetary sector, as opposed to the real sector, concerns the money market. The same tools of analysis can be applied as to other markets: supply and demand result in an equilibrium price (the interest rate) and quantity (of real money balances).

When thinking about the "supply" of money, it is natural to think of the total of banknotes and coins in an economy. That, however, is incomplete. In the United States, coins are minted by the United States Mint, part of the Department of the Treasury, outside of the Federal Reserve. Banknotes are printed by the Bureau of Engraving & Printing on behalf of the Federal Reserve as symbolic tokens of electronic credit-based money that has already been created or more precisely, issued by private banks through fractional reserve banking.

In this respect, all banknotes in existence are systematically linked to the expansion of the electronic credit-based money supply. However, coinage can be increased or decreased outside this system by Legal Mandate or Legislative Acts. However, at present the coin base is held in check and used as a complementary system rather than a competitive system with private bank issue of electronic credit-based money. The common practice is to include printed and minted money supply in the same metric M0.

The more accurate starting point for the concept of money supply is the total of all electronic credit-based deposit balances in bank (and other financial) accounts (for more precise definitions, see below) plus all the minted coins and printed paper. The M1 money supply is M0, plus the total of (non-paper or coin) deposit balances without any withdrawal restrictions (restricted accounts that you can't write checks on are put in the next level of liquidity, M2).

The relationship between the M0 and M1 money supplies is the money multiplier — basically, the ratio of cash and coin in people's wallets and bank vaults and ATMs to Total balances in their financial accounts. The gap and lag between the two (M0 and M1 - M0) occurs because of the system of fractional reserve banking.

Scope

Because (in principle) money is anything that can be used in settlement of a debt, there are varying measures of money supply. The narrowest (i.e., most restrictive) measures count only those forms of money available for immediate transactions, while broader measures include money held as a store of value

United States

U.S. Money Supply from 1959-2006

The most common measures are named M0 (narrowest), M1, M2, and M3. In the United States they are defined by the Federal Reserve as follows:

• M0: The total of all physical currency, plus accounts at the central bank which can be exchanged for physical currency.
• M1: M0 + the amount in demand accounts ("checking" or "current" accounts).
• M2: M1 + most savings accounts, money market accounts, and certificate of deposit accounts (CDs) of under $100,000.
• M3: M2 + all other CDs, deposits of eurodollars and repurchase agreements.

As of March 23, 2006, information regarding M3 will no longer be published by the Federal Reserve. The other three money supply measures will continue to be provided in detail. On March 7th, 2006, Congressman Ron Paul introduced H.R. 4892 in an effort to reverse this change.

United Kingdom

There are just two official UK measures. M0 is referred to as the "wide monetary base" or "narrow money" and M4 is referred to as "broad money" or simply "the money supply".

• M0: Cash outside Bank of England + Banks' operational deposits with Bank of England.
• M4: Cash outside banks (ie. in circulation with the public and non-bank firms) + private-sector retail bank and building society deposits + Private-sector wholesale bank and building society deposits and CDs.v

Link with inflation

Monetary exchange equation

Money supply is important because it is linked to inflation by the "monetary exchange equation":

${\textrm {velocity}}\times {\textrm {money\ supply}}={\textrm {real\ GDP}}\times {\textrm {GDP\ deflator}}$

where:

• velocity = the number of times per year that money changes hands (if it is a number it is always simply nominal GDP / money supply)
• real GDP = nominal Gross Domestic Product / GDP deflator
• GDP deflator = measure of inflation. Money supply may be less than or greater than the demand of money in the economy

In other words, if the money supply grows faster than real GDP growth (described as "unproductive debt expansion"), inflation is likely to follow ("inflation is always and everywhere a monetary phenomenon"). This statement must be qualified slightly, due to changes in velocity. While the monetarists presume that velocity is relatively stable, in fact velocity exhibits variability at business-cycle frequencies, so that the velocity equation is not particularly useful as a short run tool. Moreover, in the US, velocity has grown at an average of slightly more than 1% a year between 1959 and 2005.

Percentage

(excerpted from "Breaking Monetary Policy into Pieces", May 24 2004, http://www.hussmanfunds.com/wmc/wmc040524.htm)

In terms of percentage changes (to a small approximation, the percentage change in a product, say XY is equal to the sum of the percentage changes %X + %Y). So:

%P + %Y = %M + %V

That equation rearranged gives the "basic inflation identity":

%P = %M + %V - %Y

Inflation (%P) is equal to the rate of money growth (%M), plus the change in velocity (%V), minus the rate of output growth (%Y).

Money Supply and Cash

In the U.S., as of July 28, 2005, M1 was about $1.4 trillion, M2 about $6.5 trillion, and M3 about $9.7 trillion. If you split all of the money equally per person in the United States, each person would end up with roughly $30,000 ($9,700,000M/300M). The amount of actual physical cash M0 was $688 billion in 2004, roughly double the $328 billion in cash and cash equivalents on deposit at Citigroup as of the end of that year and roughly $ 2,125 per person in the US.

The Central Bank

The United States supply of money, outside of coins minted by the United States Mint, can increase only if the private banks issue more by loaning into circulation through Fractional Reserve Bank Lending Practices. Subsequently paper notes are increased only as they are printed by the BEP on behalf of the Federal Reserve Fractional Banking System and are swapped at par value by the Federal Reserve Bank with Private Banks for their already issued electronic credits, which are then expunged (some believe retained) from the system by the Federal Reserve Bank. Thus, these printed money tokens (notes) merely replace already issued electronic credits on a one-for-one basis.

The larger definitions of the money supply, M1, M2, and M3, are types of deposit accounts. The first balance sheet item in a bank is usually deposits. Of the money in a bank deposit, depending on reserve requirements, either the whole sum or some fraction of it can immediately be lent out. The borrower can buy an asset and the seller of that asset can place the proceeds in another money supply constituent deposit. The money supply has just increased, because both the original and secondary deposits count as part of the money supply. That money can therefore continue to increase many times over. The Federal Reserve decides the level of "reserves of depository institutions".

Monetary policy has effects on employment and output in the short run, but in the long run, it primarily affects prices.

The balance sheets

This is what money supply growth may look like starting with 1 new dollar of deposits. The money is moving from left to right. The Central Bank injects money from its reserve into the economy by buying a government bond from Bank 1 for $1, Bank 1 lends the proceeds to Person 1, who buys an asset from Person 2, who deposits the proceeds at Bank 2, who loans it to Person 3, who buys a service from Person 4, who deposits the proceeds in Bank 1, and the money supply becomes $3.

Central Bank Assets Gov. debt (to B1) $1 Liabilities - -

Bank 1 Assets Loan (to P1) $1 Liabilities Deposit (from P4) $1

Person 1 Assets Investment (to P2) $1 Liabilities Loan (from B1) $1

Person 2 Assets Deposit (to B2) $1 Liabilities - -

Bank 2 Assets Loan (to P3) $1 Liabilities Deposit (from P2) $1

Bank reserves at Central Bank

When a central bank is "easing", it triggers an increase in money supply by purchasing government securities on the open market thus increasing available funds for private banks to loan through fractional reserve banking (the issue of new money through loans) and thus grows the money supply. When the central bank is "tightening", it slows the process of private bank issue by selling securities on the open market and pulling money (that could be loaned) out of the private banking sector. It reduces or increases the supply of short term government debt, and inversely increases or reduces the supply of lending funds and thereby the ability of private banks to issue new money through debt.

The operative notion of easy money is that the central bank creates new bank reserves (in the US known as "federal funds"), which let the banks lend out more money. These loans get spent, and the proceeds get deposited at other banks. Whatever is not required to be held as reserves is then lent out again, and through the magic of the "money multiplier", loans and bank deposits go up by many times the initial injection of reserves.

However in the 1970s the reserve requirements on deposits started to fall with the emergence of money market funds, which require no reserves. Then in the early 1990s, reserve requirements were dropped to zero on savings deposits, CDs, and Eurocurrency deposits. At present, reserve requirements apply only to "transactions deposits" - essentially checking accounts. The vast majority of funding sources used by Private Banks to create loans have nothing to do with bank reserves and in effect create what is known as "moral hazard" and speculative bubble economies.

These days, commercial and industrial loans are financed by issuing large denomination CDs. Money market deposits are largely used to lend to corporations who issue commercial paper. Consumer loans are also made using savings deposits which are not subject to reserve requirements. These loans can be bunched into securities and sold to somebody else, taking them off of the bank's books.

The point is simple. Commercial, industrial and consumer loans no longer have any link to bank reserves. Since 1995, the volume of such loans has exploded, while bank reserves have declined.

In recent years, the irrelevance of open market operations has also been argued by academic economists renown for their work on the implications of rational expectations, including Robert Lucas, Jr., Thomas Sargent, Neil Wallace, Finn E. Kydland, Edward C. Prescott and Scott Freeman.

Arguments and criticism

One of the principal jobs of central banks (such as the Federal Reserve, the Bank of England and the European Central Bank) is to keep money supply growth in line with real GDP growth. Central banks do this primarily by targeting some inter-bank interest rate (in the U.S., this is the federal funds rate) through open market operations.

A very common criticism of this policy, originating with the creators of GDP as a measure, is that "real GDP growth" is in fact meaningless, and since GDP can grow for many reasons including manmade disasters and crises, is not correlated with any known means of measuring well-being. This use of the GDP figures is considered by its own creators to be an abuse, and dangerous. The most common solution proposed by such critics is that money supply (which determines the value of all financial capital, ultimately, by diluting it) should be kept in line with some more ecological and social and human means of measuring well-being. In theory, money supply would expand when well-being is improving, and contract when well-being is decreasing, giving all parties in the economy a direct interest in improving well-being.

This argument must be balanced against what is nearly dogma among economists: that the control of inflation is the main (or only) job of a central bank, and that any introduction of non-financial means of measuring well-being has an inevitable domino effect of increasing government spending and diluting capital and the rewards of gainfully employing capital.

Currency integration is thought by some economists — Robert Mundell, for example — to alleviate this problem by ensuring that currencies become less competitive in the commodity markets, and that a wider political base be employed in the setting of currency and inflation and well-being policy. This thinking is in part the basis of the Euro currency integration in the European Union.

Some economists argue for the money supply to remain constant at all times. With growth in production, this would result in falling prices. A constant money supply will keep nominal incomes constant over time. However, falling prices will lead to an increase in real incomes.

Money supply remains one of the most controversial aspects of economics itself.

United States monetary base

United States monetary base at the end of September 2004.

Monetary base (billions of dollars) (not seasonally adjusted)

Monetary Base
Reserves of depository institutions	46.4
Reserve balances with F.R. Banks	13.0
Vault cash surplus	11.4
Currency	688.2
Sum	759.0

United States Money Supply

This table shows the United States money supply as reported by the Fed on Sep 30, 2004.

Money Supply (billions of dollars)
(not seasonally adjusted)

M0 (not seasonally adjusted, not adjusted for changes in reserve requirements)
Currency (The diff between total reserves and the Monetary Base as reported in H.3)	674.4
Bank's total reserves at the Fed	46.1
M0 (Monetary Base)	720.5
M1
Demand Deposits	321.0
Other Checkable Deposits	319.5
M1 (Monetary Base)	1,361.0
M2
Savings deposits	3,472.5
Small-denomination time deposits	795.6
Retail money funds	729.5
M3
Institutional money funds	1,071.6
Large-denomination time deposits	1,018.2
Repurchase agreements	537.3
Eurodollars	322.2
Sum	9,311.7

Comparable numbers (billions of dollars) (not seasonally adjusted)

GDP (seasonally adjusted)	11,643.0
Credit market Debt Outstanding	35,181.7
Derivatives (notional)	79,400.0

The only deposits that have "reserve requirements" are the M1 "checking deposits".

Discontinuance of M3 Publication Data

In a press release dated 10 November, 2005, the Board of Governors of the Federal Reserve System announced that it would cease publication of the M3 monetary aggregate. The Board stated that M3 "does not appear to convey any additional information about economic activity that is not already embodied in M2," and that the decision was reached largely because "the costs of collecting the underlying data and publishing M3 outweigh the benefits."

Latest US M3 numbers

According to the last published data from 16 March, 2005, M3 has been growing at an annual rate of over 8.22%. As of 16th March 2006 M3 was $10.34 trillion. One year earlier, on 14th March 2005 the M3 was $9.55 trillion.

Controlling money supply by issuing debt

The government can control the growth of M3 through the issuance of new Government debt instruments. Money which is re-invested back into US Government debt—such as treasury bonds and treasury bills—ceases to be part of M3. Thus, if a government wishes to slow the growth of M3, and thus prevent the economy from overheating, it can raise interest rates, and, therefore, withdraw money from M3 and transfer it into Government debt. Between 14, March 2005 and 16, March 2006 total US National Debt rose by 6.71% from $7.75 trillion to $8.27 trillion. These figures inform us that the actual issuance of money exceeded the increase in M3. In March of 2006, the US Congress agreed to raise the National Debt Ceiling an additional $781 billion and, thus, prevent a first-ever default on US Treasury notes. As of 15 April, 2006, The National Debt Ceiling stands at just under $9 trillion.

ECB Target

The European Central Bank has set a target rate of 4.5% for M3 growth but has overshot that target by almost double since the inception of the Euro.

Expanding the paper money supply

See also inflation.

Historically money was a metal (gold, silver, copper, etc,) or other object that was difficult to duplicate, but easy to transport and divide. Later it consisted of paper notes, now issued by all modern governments. With the rise of modern industrial capitalism it has gone through several phases including but not limited to:

1. Bank notes - paper issued by banks as an interest-bearing loan. (These were common in the 19th century but not seen anymore.)
2. Paper notes, coins with varying amounts of precious metal (usually called legal tender) issued by various governments. There is also a near-money in the form of interest bearing bonds issued by governments with solid credit ratings.
3. Bank credit through the creation of chequable deposits in the granting of various loans to business, government and individuals. (It is critical that we understand that when a bank makes a loan, that is new money and when a loan is paid off that money is destroyed. Only the interest paid on it remains.)

Thus, all debt denominated in dollars — mortgages, money markets, credit card debt, travelers cheques — is money. However, the creation of dollar-denominated debt (or any generic obligation) creates money only when a bank (as opposed to a credit card company) is granting the debt. "High powered" money (M0) is created when the elected government spends money into the economy. The money created in the bank loan process is bank money and these two forms of money trade at par one with the other. Banks are limited in the amount of loans they can grant and thus in the amount of bank money (credit) they can create by both the net assets of the bank and by reserve requirements (M0). For most intents and purposes the aggregate of M0 multiplied by the reserve requirement will be an indicator of (but this is somewhat greater than) the aggregate of loans. If additional money is needed in the banking system to allow more loans the Federal Reserve will create money by purchasing Bonds or T-bills with money created from the other. No matter who sells the bonds the money will end up in the banking system as M0. The Fed could purchase lolly pops if that would accomplish the purpose of expansion better than a purchase of Bonds.

Shrinking the paper money supply

See also deflation.

Perhaps the most obvious way money can be destroyed is if paper bills are burned or taken out of circulation by the central bank. But, it should be remembered that legal tender usually constitutes less than 4% of the broad money supply.

Current banking systems are based on fractional reserves so money can be destroyed if depositers withdraw funds from a bank. When money is withdrawn it can no longer be used for lending and just as the fractional reserve system gives leverage to the creation of money, it also gives leverage to the destruction of money. Bank savings are actually a kind of loans — savers loan their money to a bank at a low interest rate or merely in exchange for the benefit of convenience or its security (accepting that they lose a small amount of value to inflation). The bank may use this loan to manage its liabilities (its deposit liabilities created by loans). It must be recalled that the federal reserve banking system is mostly a closed system. A check written on bank A gets deposited in Bank B and a check written on bank B gets deposited in Bank C and a check on bank C gets deposited in bank A. On a good day very little borrowing needs to be done because a bank gets as much in new deposits as it does in paid out funds. Even if a bank is short of reserves it can borrow the reserves from another bank at the discount rate.

Another way money can be destroyed is when any bank loan is paid off or any government bond or T-Bill is purchased by the private sector. The money value of the contract or bond is destroyed — taken out of circulation. If a bank loan is defaulted upon then the "interest" paid by other borrowers will be employed to cover the default. A very large part of the "interest" paid on bank loans is actually a finance charge employed to cover bad loans. The group of good borrowers pay the loan instead of the original borrower. In cases where the default is huge such as loans to foreign governments Fed intervention has, in the past, rescued the banks. In this instance it would seem that the taxpayers and/or money holders (savers) will pay the debt. The effects on the money supply will be controlled, again, by the level of bond purchase or redemption or the level of T-Bill sales or purchases by the Treasury.

In extreme forms, a bank run or panic may drive a bank into insolvency and, if uninsured, the savings of all its depositors are lost. Such bank failures were a major cause of the tremendous contraction in the money supply that occurred during the Great Depression, particularly in the United States. In that country many banking reforms were subsequently enacted during the New Deal, including the creation of the Federal Deposit Insurance Corporation to guarantee private bank deposits.

Articles and books

• Monetary creation, aggregates and GDP growth On the inverse relation between Excess Money Supply and Growth. - J.P. Chevallier

External links

Data

• Trailing Five-Year U.S. Money Supply Chart
• Trailing Five-Year U.S. Money Supply Rate of Change Chart
• Aggregate Reserves Of Depository Institutions And The Monetary Base (H.3)
• U.S. M1,M2 Money Supply Historical Table
• Money Stock Measures (H.6)
• Data on Monetary Aggregates in Australia

Articles

• Do all banks hold reserves, and, if so, where do they hold them? (11/2001)
• What effect does a change in the reserve requirement have on the money supply? (08/2001)
• St. Louis Fed: Monetary Aggregates
• Anna J. Schwartz on money supply
• Discontinuance of M3 Publication

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