Money supply

What Is Money Supply?

Money supply, also known as money stock, refers to the total amount of currency and other highly liquid assets circulating in an economy at a specific point in time. It is a fundamental concept within macroeconomics, representing the pool of funds available for transactions and investments. The money supply includes physical currency (cash and coins) as well as various forms of deposits held by the public in financial institutions, which can be easily converted into cash or used for payments¹². Central banks and governmental bodies monitor the money supply closely as it can influence key economic variables such as inflation, economic growth, and interest rates.

History and Origin

The concept of money supply has evolved significantly alongside the development of financial systems. Historically, money was often based on tangible commodities like gold or silver. With the introduction of paper money and checkable deposits, these forms of money were initially convertible into commodity money. A major shift occurred on August 15, 1971, when President Richard Nixon discontinued the convertibility of U.S. dollars into gold, transforming the U.S. dollar and other currencies into "fiat money"—money that national monetary authorities can issue without being constrained by a physical commodity.
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The systematic measurement of money supply gained prominence with the rise of modern central banking. Economists and policymakers began categorizing different forms of money based on their liquidity to better understand their impact on the economy. Different measures, such as M1, M2, and M3, were developed to provide a comprehensive view of the money circulating within an economy. The relationship between money supply growth and inflation was a particularly influential idea during the 1970s and 1980s, strongly supported by the monetarist school of thought. For instance, the hyperinflation experienced by the Weimar Republic in post-World War I Germany is often cited as a historical example where a rapid increase in the money supply led to a severe devaluation of currency and skyrocketing prices.
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Key Takeaways

• Money supply is the total amount of currency and other liquid assets available in an economy.
• Central banks, like the Federal Reserve in the U.S., define and track different measures of the money supply, primarily M1 and M2.
• The money supply is a key indicator for policymakers to assess economic conditions and inform monetary policy decisions.
• Changes in the money supply can influence inflation, economic growth, and borrowing costs.
• Measures of money supply classify assets based on their liquidity, from the most liquid (currency) to less liquid forms (savings and time deposits).

Formula and Calculation

While there isn't a single universal formula for "money supply" as a whole, it is calculated by summing various monetary aggregates, each with its own definition. The primary measures used in the United States, as reported by the Federal Reserve, are M1 and M2.

M1 Money Supply:
M1 represents the narrowest measure of money supply, encompassing the most liquid forms of money used for transactions.
$\text{M1} = \text{Currency in circulation} + \text{Demand deposits} + \text{Other liquid deposits}$

• Currency in circulation: Physical banknotes and coins held by the public.
• Demand Deposits: Funds held in checking accounts that can be withdrawn or transferred without restrictions.
• Other liquid deposits: Includes savings deposits and other checkable deposits,.^{9
  8}
  M2 Money Supply:
  M2 is a broader measure, including M1 plus less liquid assets that can be readily converted into cash.
  $\text{M2} = \text{M1} + \text{Small-denomination time deposits} + \text{Retail money market mutual fund shares}$
• M1: All components of M1 as defined above.
• Small-denomination Time Deposits: Deposits issued in amounts less than $100,000 that earn interest and have a specified maturity date.
• Retail Money Market Funds: Shares in money market mutual funds held by individual investors,.^{7
  6}
  It's important to note that the Federal Reserve discontinued reporting M3 in 2006, and M0 (monetary base) is primarily used by central banks themselves.

Interpreting the Money Supply

Interpreting the money supply involves analyzing its growth rate and composition to understand economic trends. A growing money supply can indicate increased economic activity and potentially lead to higher Gross Domestic Product (GDP) and employment. Conversely, a rapidly expanding money supply without corresponding growth in goods and services can contribute to inflation. Policymakers at the central bank pay close attention to these figures. For example, if the money supply is growing too quickly, the central bank might consider tightening monetary policy to curb inflationary pressures. If it's growing too slowly, potentially signaling a slowdown, policymakers might consider measures to stimulate economic growth.

Hypothetical Example

Imagine the central bank of a small nation, "Diversia," is concerned about slowing economic activity. To stimulate the economy, the central bank decides to implement an expansionary monetary policy. One action they take is to lower the reserve requirements for commercial banks. Previously, banks had to hold 10% of their deposits as reserves; now, this is reduced to 5%.

Before the change, if a bank had $100 million in deposits, it had to hold $10 million in reserves, leaving $90 million available for loans. After the change, with a 5% reserve requirement, the bank only needs to hold $5 million in reserves, freeing up an additional $5 million for lending. As banks lend out these newly available funds, the money is deposited into other accounts, which then becomes available for further lending, creating a multiplier effect on the money supply. This increase in the money supply aims to encourage borrowing and spending, boosting economic activity in Diversia.

Practical Applications

The money supply is a critical indicator used across various financial and economic sectors:

• Monetary Policy Formulation: Central banks primarily use money supply data to guide their monetary policy decisions, including setting interest rates and conducting open market operations. Their goal is often to maintain price stability and foster sustainable economic growth.
  ⁵* Economic Analysis: Economists and financial analysts study changes in the money supply to forecast future economic trends, such as potential inflationary or deflationary pressures.
• Investment Decisions: Investors may consider money supply trends when making portfolio decisions. For instance, a rapidly increasing money supply might suggest a higher risk of inflation, leading investors to favor inflation-hedging assets.
• Academic Research: Researchers use money supply data to study its relationship with other macroeconomic variables, contributing to the understanding of economic dynamics.
• International Finance: Global institutions like the International Monetary Fund (IMF) analyze money supply data across countries to assess financial stability and economic health on a global scale. The Federal Reserve Board publishes detailed money stock measures regularly, which are accessible to the public and used by analysts worldwide.
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Limitations and Criticisms

While the money supply is a vital economic indicator, its direct relationship with economic activity, particularly inflation, has been a subject of debate and has evolved over time. Early monetarist theories suggested a strong, direct link between money supply growth and inflation. However, in modern economies, this relationship has become less straightforward due to several factors:

• Velocity of Money: The "velocity of money"—the rate at which money changes hands—is not constant. A large money supply might not lead to inflation if people are holding onto money rather than spending it.
• Financial Innovation: The proliferation of new financial products and payment methods can make it challenging to define and measure the "true" money supply accurately. For example, the increasing use of digital payments and alternative financial instruments can complicate traditional measures.
• Global Capital Flows: In an interconnected global economy, large capital flows across borders can influence domestic money supply in ways not always captured by national measures.
• Central Bank Tools: Modern central banking relies on a broader set of tools beyond directly controlling the quantity of money, such as targeting interest rates and managing expectations. This has led some economists to argue that the money supply has become less critical for policy purposes,.
• ³Measurement Changes: The Federal Reserve's redefinition of M1 and M2 in May 2020, which notably shifted savings deposits into M1, illustrates how the components of money supply can change, impacting historical comparisons and interpretations.

The²se complexities mean that while the money supply remains a relevant economic statistic, it is now considered one of many indicators that policymakers review, rather than the sole determinant of economic outcomes.

¹Money Supply vs. Monetary Base

It is common to confuse "money supply" with the "monetary base," but they represent different measures of money within an economy.

The key difference lies in scope and control: the monetary base is a narrower measure directly controlled by the central bank, while the broader money supply is influenced by both the central bank and the lending activities of commercial banks.

FAQs

What are the main components of money supply?

The main components of money supply typically include physical currency (cash and coins), demand deposits (checking account balances), savings accounts, time deposits, and shares in retail money market funds. These are categorized based on their liquidity.

How does the central bank influence money supply?

A central bank influences the money supply primarily through three tools: setting the reserve requirements for banks, adjusting the discount rate (the interest rate at which banks can borrow from the central bank), and conducting open market operations (buying or selling government securities). These actions affect the amount of funds available for banks to lend, thus impacting the overall money supply.

Why is money supply important for the economy?

Money supply is important because it influences key economic variables. An appropriate level of money supply can support economic growth and employment, while an excessive increase can lead to inflation. Conversely, a contraction in the money supply can contribute to economic slowdowns or even deflation.

What are M1 and M2?

M1 and M2 are specific measures of the money supply defined by central banks. M1 is the narrowest measure, including physical currency, checking deposits, and other highly liquid accounts. M2 is a broader measure that includes all of M1 plus savings deposits, small-denomination time deposits, and retail money market funds.