Money supply

Money supply, "monetary aggregates" or "money stock" is a macroeconomic concept defining the quantity of money available within a nation’s economy which can be used to purchase goods, services, or financial securities. A nation’s money supply is comprised of all currency including dollar bills, coins and deposits issued by the nation’s central bank. Currency consists of the total amount of dollar bills and coins circulated throughout the economy. Reserves mark the sum of all bank vault values and all reserve deposits held by the central bank. Combined, a nation’s currency and the level of bank reserves comprise the total money supply, or monetary base. Total money supplies are generally measured by the sum of currency in circulation, checking deposits, and saving deposits. The U.S. Federal Reserve uses three definitions of money to measure its money supply; M1 which measures money in exchange, M2 which measures money in storage, and M3 which measures objects that can act as money substitutes.

Determination

A nation’s money supply is determined by the policy actions of its central banking institution. Commercial banks, as required by the central bank, must keep a fraction of all accepted deposits on reserve either in bank vaults or in central bank deposits. Accordingly, a nation’s central bank can maintain control of such reserves by lending to commercial banks and altering the rate of interest to be charged on such loans. These actions are known as open market operations and allow central banks to achieve a desired level of reserves.

Open market operations, a dominant instrument of monetary policy, mark the behavior of a nation’s central bank to trade or purchase government securities for cash in attempts to expand or contract the total money supply. Purchases of government securities prove to expand the total monetary base, while the selling of government securities will ultimately contract a nation’s monetary base. The responsibility of a central bank to control national rates of interest also enables it to control the amount of loans demanded by the public. A higher interest rate will spark an increase in the demand for discount loans, while lower interest rates will produce a reverse effect.

A nation’s central bank is also responsible for supplying commercial banks with enough currency to meet consumer demand. By controlling the national interest rate, a central bank can adequately meet and further dictate the consumer demand for money. A decrease in the interest rate will spark an increase in the consumer demand for money; an increase in the rate of interest will lessen its demand. Changes in the interest rate also play a role in the setting of price levels. An increase in the demand for money will increase spending levels and cause prices to rise. A decrease in the demand for money will slow spending levels and produce a subsequent decrease in price levels. If consumers expect price levels to fall, the demand for money will increase. If consumers expect price levels to increase, the demand for money will decline.

A nation’s money supply is closely tied to all levels of its economic activity. Short-run changes in a nation’s money supply may prove to have immediate economics effects on employment levels, output levels, and real income levels while the long-run behavior of a nation’s money supply often determines levels of price inflation. Increases in a nation’s money supply have been shown to increase levels of aggregate demand, raising with it spending levels, production, the demand for labor and for capital goods. A decrease in a nation’s money supply has been shown to reverse such effects; consumer demand falls, spending levels tighten and the level of economic activity declines.

In determining a nation’s money supply, its central bank first sets the supply of the monetary base and upholds certain restrictions on the value of assets and liabilities held by smaller commercial banks. Though the consumer demand for liquidity is dictated by the public, small commercial banks are required to meet consumer demand and do so by identifying certain conditions including a set interest rate which apply to the loaning of bank liabilities. Commercial bank behavior, ultimately regulated by the nation’s central banking institution, and conjunction with consumer demand define the total stock of money, bank credit and rates of interest which shape national economic conditions. The value of the money supply is determined by the money multiplier and the monetary base. The monetary base consists of the total quantity of government-produced money and includes all currency held by the public and reserves held by commercial banks. The central bank retains tight control over its nation’s money supply through the use of open market operations and the lending of loans.

The money multiplier is jointly determined by the economic behavior of consumers, commercial banks and the central bank. Factors which limit the money multiplier include consumer expectations and their decisions to hold money, and the liquidity preferences of commercial banks to hold excess reserves. In short, the money multiplier must account for various levels of consumer demand, private bank demands and any resulting market conditions. The value of the money multiplier is directly related to consumer behavior in that an increase in the demand for money will subsequently decrease the size of the money multiplier. An increase in the demand for excess reserves by private banks will also diminish the money multiplier, decreasing with it the value of the money supply, the amount of bank loans and deposits. Changes in the money multiplier represent short-run fluctuations and often denote temporary changes to the total money supply.

Monetary Aggregates

Different measures of a nation's money supply reflect various degrees of asset liquidity, which marks the ease at which a monetary asset can be turned into cash. Liquid assets include coins, paper currency, checkable-type deposits and traveler’s checks. Less liquid assets include money market deposits and saving account deposits. Measure MI, the most narrow of measures, includes the most liquid forms of monetary assets: all currency and bank deposits held by a nation’s public. M2, a slightly broader measure includes all values incorporated under MI, in addition to assets held in savings accounts, certain time deposits and mutual fund balances.

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 treasury securities. 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 involves 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 allow the banks to lend more money. These loans are spent and the proceeds are 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 1970s, central bank reserve requirements on deposit started to fall with the emergence of money market funds, which required no holding of reserves. In the early 1990s, reserve requirements were dropped to zero on savings deposits, Certificate of deposit (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.

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 nineteenth 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 securities, such as treasury 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 four percent 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 treasury bill (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. Many banking reforms were subsequently enacted during the New Deal, including the creation of the Federal Deposit Insurance Corporation (FDIC) to guarantee private bank deposits.

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 Federal Reserve, the Bank of England and the European Central Bank are listed below.

The Federal Reserve

The U.S. Federal Reserve 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 Federal Reserve 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 Bank of England

The Bank of England is the central banking institution of the United Kingdom, retaining control over its money supply and the determination of its interest rate. The Bank of England is responsible for controlling the U.K.’s foreign exchange rates and gold reserves and aims toward ensuring monetary and financial stability. The interest rate set by the Bank of England is set through financial market operations and dictates the rate at which the Bank of England lends credit to various financial institutions. The Bank retains a monopoly on the issuance of banknotes within the United Kingdom and, under the Bank’s Monetary Policy Committee, aims to set a general interest rate that meets an overall economic inflation target.

The European Central Bank

The European Central Bank (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 constrain consumer purchasing power throughout the EU. In order to maintain economic health, contemporary ECB policies have targeted annual inflation rates that ensure less than two percent increases in consumer price levels. By retaining tight control of the money supply to limit inflation levels, 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.

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 the standard view 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 Nobel Prize winner 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 conflict, policy regarding a nation’s money supply remains one of the most controversial aspects of economics itself.

Link with Inflation

Monetary Exchange Equation

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

U.S. M3 money supply as a proportion of gross domestic product.

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 grew at an average of slightly more than one percent per year between 1959 and 2005.

Basic Inflation Identity

The exchange equation is usually written PY = MV, Where the amount of nominal output purchased during any period (the price level P times real output Y) is equal to nominal money spent (the money stock M times the rate of turnover or “velocity” of money V).

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).

References

ISBN links support NWE through referral fees

• Hussman, John P. Breaking Monetary Policy into Pieces. Hussman Funds Weekly Market Comment. Hussman Funds 24 May, 2004.
• Barron’s Legal Dictionary. Money Supply. Barron’s Educational Series Inc. Barron’s Law Dictionary 20 December, 2006.
• Schwartz, Anna. Money Supply. The Concise Encyclopedia of Economics. 19 February, 2007.
• Federal Reserve Bank of New York. The Money Supply. 19 February, 2007.
• Encyclopedia of Business and Finance. Money Supply. The Gale Group Inc., 2001. 19 February 2007.

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)

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