Money supply

Money supply, "monetary aggregates" or "money stock" is a macroeconomic concept defining the quantity of money available within a nation’s economy used to purchase economic goods, services, and financial securities. The monetary sector of a nation’s economy, as opposed to its real sector, concerns the money market. The same tools of analysis can be applied to this market as can be applied to other goods markets: supply and demand result in an equilibrium price, which defines the interest rate and quantity of real money balances.

Money Supply

When thinking about a nation’s "supply" of money, it is natural to think of the total of banknotes and coins in an economy. However in many countries, these do not calculate into a nation’s total money supply. For instance, in the United States, coins are minted by the United States Mint, part of the United States Department of the Treasury, which lies outside of the U.S. 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 issued by private banks. The term private bank as used here refers to a bank that is not government owned.

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. During most periods the coin base is held in check and used as a complementary system rather than a competitive system with private bank issues of electronic credit-based money. The common practice is to include printed and minted money supply in the same metric, define as M0.

The more accurate starting point for the concept of the money supply is the total of all electronic credit-based deposit balances held in financial accounts plus all the minted coins and printed paper. The M1 money supply consists of all noted and minted monies, or M0, plus the total of non-paper or coin deposit balances without any withdrawal restrictions. Restricted accounts of which one cannot write checks on are put in the next level of liquidity, defined by money supply M2.

The relationship between the M0 and M1 money supplies is the money multiplier which defines 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 money supplies occurs because of the system of fractional reserve banking, referring to a banking practice where more money is issued than what is held by the central bank in reserves. The U.S. Federal Reserve Board maintains such a system.

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

Monetary Exchange Equation

A nation’s money supply is important because it is linked to price inflation by the "monetary exchange equation", which follows:

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

Within this equation:

• Velocity = The number of times per year that money changes hands.
• Real GDP = Nominal Gross Domestic Product / GDP deflator.
• GDP Deflator = A Measure of inflation, whereas the money supply may be less than or greater than the demand of money in the economy.

If the money supply grows faster than the growth of real GDP, described as "unproductive debt expansion", inflation is likely to follow. While followers of the monetarist school of economics presume that velocity is relatively stable, velocity in fact exhibits variability at business-cycle frequencies, so that the velocity equation is not particularly useful as a short run tool. Moreover, in the U.S., velocity has grown at an average of slightly more than 1% per year between 1959 and 2005.

Basic Inflation Identity

Inflation is inherently linked with the percentage change of both the rate of money growth and the change in velocity. It also accounts for the rate of output growth. In analyzing percentage changes, a percentage change in product XY is equal to the sum of the percentage changes %X + %Y. This follows:

%P + %Y = %M + %V

Rearranged, this equation provides the "basic inflation identity", which follows:

%P = %M + %V - %Y

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

The United States

U.S. Money Supply from 1959-2006

Under the U.S. Federal Reserve, the most common measures of money supply are termed M0, M1, M2, and M3. The Federal Reserve defines such measures as follows:

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

The U.S. government can control the growth of M3 through the issuance of new Government debt instruments. Money which is re-invested back into U.S. Government debt, including treasury bonds and treasury bills, ceases to be part of M3. Thus, if a government wishes to slow the growth of M3, it can raise interest rates, therefore withdrawing money from M3 and transferring it into Government debt.

The United Kingdom

Within the United Kingdom, there are just two official money supply measures. M0, which is referred to as the "wide monetary base" or "narrow money", and M4, which is referred to as "broad money" or simply "the money supply". These measures are defined as such:

• M0: All cash outside the Bank of England + private banks' operational deposits with the Bank of England.
• M4: All cash outside banking institutes, either 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 certificates of deposits.

Central Bank Policies

When a central bank is "easing", it triggers an increase in money supply by purchasing government bonds, or securities, on the open market thus increasing available funds for private banks to loan through fractional reserve banking , which is the issue of new money through loans. This proves to increase 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 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 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 "money multiplier", loans and bank deposits will increase by many times the initial injection of reserves.

In the 1970’s, central bank reserve requirements on deposit started to fall with the emergence of money market funds, which require no holding of reserves. In the early 1990’s, reserve requirements were dropped to zero on savings deposits, CDs, and Eurocurrency deposits. At present, reserve requirements apply only to "transactions deposits", which include mainly 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.

Over time, commercial, industrial and consumer loans have ceased to link with bank reserves. Since 1995, the volume of such loans has exploded, while bank reserves have declined.

Expanding the Money Supply

Historically, money was defined in terms of metal, and included gold, silver, and copper. Money also constituted other objects that were difficult to duplicate, but easy to transport and divide. Later, money consisted of paper notes, which are now issued by all modern governments. With the rise of modern industrial capitalism, money has gone through several phases including but not limited to; bank notes including paper issued by banks as an interest-bearing loan that common to the 19th century, and paper notes consisting of coins with varying amounts of precious metal, termed legal tender, that are issued by various governments. There is also a near-money in the form of interest bearing bonds issued by governments with solid credit ratings. Money has also consisted of bank credit through the creation of checkable deposits in the granting of various loans to business, government and individuals.

Thus, all debt denominated in dollars, including mortgages, money markets, credit card debt, and travelers checke, is money. However, the creation of dollar-denominated debt, or any generic obligation, creates money only when a bank is granting the debt. "High powered" money, or M0, is created when the elected government spends money into the economy. The money created in the bank loan process is termed bank money. These 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 or credit they can create by both the net assets of the bank and by reserve requirements. For most intents and purposes the aggregate of M0 multiplied by the reserve requirement will be an indicator of the aggregate of loans. If additional money is needed in the banking system to allow more loans, the central bank 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.

Shrinking the Money Supply

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 depositors 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 deposit liabilities.

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 when 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. A group of good borrowers pay the loan instead of the original borrower. In cases where the default is large such as loans to foreign governments Federal intervention has, in the past, rescued the banks. In this instance it would seem that the taxpayers and/or money holders 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.

Policy Criticism

One of the principal jobs of central banks, such as the U.S. 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 United States, this is the federal funds rate obtained through the use of open market operations.

A very common criticism of this target policy 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 measurement well-being. The policy use of GDP figures is considered to be an abuse, and a common solution proposed by such critics is that a nation’s money supply should be kept in line with a more ecological, social and human mean of well-being. In theory, money supply would expand when well-being is improving, and contract when well-being is decreasing. Proponents believe this policy to give 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 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.

Currency integration is thought by some economists, including Robert Mundell, 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 within 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. Due to such confliction, policy regarding a nation’s money supply remains one of the most controversial aspects of economics itself.

Monetary Objectives

Though a nation’s money supply delineates the total amount of money within a national economy, nations also employ various methods or principles to measure their total money stock. Similarly, a nation’s central banking institution retains various monetary objectives to ensure national economic stability. Some objectives belonging to the U.S. Federal Reserve, the Bank of England and the European Central Bank are listed below.

The Federal Reserve

The U.S. Federal Reserve, or Fed, is responsible for monitoring the money supply of the United States. When aiming to expand the U.S. money supply by means of expansive monetary policy, the Fed adds more reserves to the banking system in order to allow private banks more liquidity and ensure their ability to issue loans. The Federal Reserve aims to foster economic growth within the United States by maintaining stability within the national money supply and regulating the actions of private banking institutions throughout the U.S.

The European Central Bank

The European Central Bank, or the ECB, is responsible for controlling the money supply and setting the rate of interest, or the discount rate, for the twenty-five countries that comprise the European Union. The main objective of the ECB is to ensure price stability and to limit inflationary pressures that limit consumer purchasing power throughout the EU. In order to maintain economic health, contemporary ECB policies have targeted annual inflation rates that ensure less than 2% increases in consumer price levels. By retaining tight control of the money supply to limit inflation, and by further monitoring present and past price trends, the ECB aims to adequately assess the risks to price stability and attempt to assuage them.

Sources

• Chevallier, J.P. On the Inverse Relation Between Excess Money Supply and Growth. Monetary Creation, Aggregates and GDP Growth.
• Hussman, John P. Breaking Monetary Policy into Pieces. Hussman Funds 24 May, 2004.
• Barron’s Legal Dictionary. Money Supply. Barron’s Educational Series Inc. Barron’s Law Dictionary 20 December, 2006.

External links

• Trailing Five-Year U.S. Money Supply Chart
• Trailing Five-Year U.S. Money Supply Rate of Change Chart
• U.S. M1,M2 Money Supply Historical Table
• Money Stock Measures (H.6)
• 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)
• Anna J. Schwartz on money supply

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