Nominal money supply

What Is Nominal Money Supply?

Nominal money supply refers to the total quantity of money available in an economy at a specific point in time, without adjusting for inflation. It represents the face value of all currency, checking account deposits, and other liquid assets that households and businesses can use to make payments or hold as short-term investments. This core concept is fundamental to macroeconomics, a branch of economics that studies the behavior and performance of an economy as a whole, focusing on issues like economic growth, unemployment, and price levels. Central banks closely monitor the nominal money supply as a key indicator of economic activity and a primary lever for conducting monetary policy. The Federal Reserve, for instance, provides various measures of the money supply, including M1 and M2, which encompass different levels of liquidity⁵.

History and Origin

The concept of money supply and its measurement evolved significantly with the development of financial systems and the establishment of central banking. Historically, money primarily consisted of physical commodities like gold and silver, or later, paper money convertible into these commodities. The need to quantify the amount of circulating money became crucial as economies grew more complex and fractional-reserve banking gained prominence.

The establishment of central banks played a pivotal role in formalizing the monitoring and control of the money supply. For instance, the Swedish Riksbank, founded in 1668, is often recognized as the first institution to function as a central bank⁴. In the United States, a uniform national currency was established with the national banking system in 1863, leading to a more structured approach to understanding the nation's financial liquidity. The creation of the Federal Reserve in 1913 further solidified the central bank's role in managing the quantity and elasticity of money, initially to prevent banking panics and later to influence broader economic conditions³. The ongoing evolution of financial products and technologies continues to challenge and refine how central banks define and measure the nominal money supply.

Key Takeaways

• Nominal money supply is the total amount of money in an economy, measured at face value, without adjusting for price changes.
• It includes physical currency, checking deposits, and other highly liquid assets.
• Central banks monitor nominal money supply to guide their monetary policy decisions, influencing factors like interest rates and economic activity.
• Changes in nominal money supply can impact purchasing power and the general price level in an economy.
• Unlike real money supply, nominal money supply does not account for the effects of inflation or deflation on the value of money.

Formula and Calculation

While nominal money supply itself is a direct measure of the total stock of money, its relationship with economic activity is often illustrated using the Quantity Theory of Money (QTM). This theory, in its simplest form, provides a framework that relates the money supply to the price level and the volume of transactions in an economy. The formula for the Quantity Theory of Money is:

$M \times V = P \times Q$

Where:

• (M) = Nominal Money Supply (e.g., M1 or M2)
• (V) = Velocity of Money (the average number of times a unit of money is spent on new goods and services in a specific period)
• (P) = Aggregate Price Level
• (Q) = Real Output (or Real Gross Domestic Product)

In this formula, the left side ((M \times V)) represents the total nominal spending in the economy, and the right side ((P \times Q)) represents the nominal value of all goods and services produced, which is equivalent to nominal Gross Domestic Product. While the nominal money supply ((M)) is a directly measurable quantity, (V), (P), and (Q) are inferred or measured separately. The QTM suggests that, holding (V) and (Q) constant, a change in (M) will lead to a proportional change in (P).

Interpreting the Nominal Money Supply

Interpreting the nominal money supply involves understanding its implications for prices, economic activity, and the effectiveness of monetary policy. A growing nominal money supply, all else being equal, suggests more currency is available for transactions and investment. This can lead to increased aggregate demand, potentially stimulating economic growth. However, if the increase in nominal money supply outpaces the growth in the supply of goods and services, it can result in inflation, as too much money chases too few goods. Conversely, a contraction in the nominal money supply can indicate a slowdown in economic activity, potentially leading to deflation or a recession.

Central banks, such as the Federal Reserve, closely monitor the various measures of nominal money supply (M1, M2, etc.) to gauge the overall liquidity in the financial system. For instance, an unexpected surge in the nominal money supply might signal inflationary pressures, prompting the central bank to consider tightening monetary policy by raising interest rates or reducing its bond purchases. Conversely, a stagnant or declining nominal money supply could indicate a need for expansionary measures to inject more liquidity into the financial markets and encourage lending and spending.

Hypothetical Example

Consider a hypothetical economy, "Economy A," which currently has a nominal money supply (M2) of $10 trillion. The central bank of Economy A decides to implement an expansionary monetary policy to stimulate job creation and investment. It does this by conducting large-scale open market operations, purchasing government bonds from commercial banks.

Through these purchases, the central bank injects new reserves into the banking system. The banks, now having excess reserves, are incentivized to lend more money to businesses and consumers. For instance, if the central bank buys $100 billion in bonds, this $100 billion directly increases the nominal money supply. These funds are then deposited into various bank accounts. As banks lend out these new deposits, the money circulates, and through the money multiplier effect, the initial $100 billion injection could lead to a much larger increase in the overall nominal money supply. This expanded pool of available money could then lead to increased consumer spending and business investment, supporting economic growth. However, if output doesn't keep pace, this increase in nominal money supply could also lead to upward pressure on prices, diminishing the purchasing power of each unit of currency.

Practical Applications

The nominal money supply serves several critical practical applications in economic and financial analysis:

• Monetary Policy Implementation: Central banks around the world, including the Federal Reserve, use nominal money supply data as a key input for formulating and implementing monetary policy. By influencing the growth rate of the money supply through tools like interest rates and quantitative easing, they aim to achieve macroeconomic objectives such as price stability and maximum employment². For example, during periods of economic slowdown, a central bank might increase the nominal money supply to lower borrowing costs and encourage lending and investment.
• Inflation Forecasting: While the relationship is not always direct or stable, rapid increases in the nominal money supply, especially when not accompanied by corresponding increases in real output, can be an indicator of future inflationary pressures. Economists and policymakers often analyze trends in nominal money supply to anticipate potential changes in the general price level.
• Economic Analysis: Analysts use nominal money supply figures to assess the overall liquidity and health of an economy. A robust and stable nominal money supply is generally seen as conducive to smooth economic transactions and sustained economic growth. Deviations from desired growth rates can signal imbalances that require policy intervention.
• Investment Decisions: Investors sometimes look at money supply trends as a factor in their decision-making. For instance, a rapidly expanding nominal money supply might suggest a favorable environment for asset prices, while a contracting money supply could signal an impending economic downturn or even deflation, influencing asset allocation strategies.

Limitations and Criticisms

While nominal money supply is a crucial economic indicator, its direct relationship with economic outcomes has faced considerable debate and criticism, particularly regarding its stability and predictability. One significant limitation stems from changes in the velocity of money, which is the rate at which money is exchanged in an economy. If the velocity of money declines significantly, an increase in the nominal money supply may not translate into increased spending or inflation, as theory might suggest. This phenomenon was notably observed after the 2008 financial crisis and during the COVID-19 pandemic, when massive increases in the nominal money supply did not lead to proportional inflation due to a sharp drop in velocity¹.

Other criticisms and limitations include:

• Financial Innovation: The ever-evolving nature of financial products and services makes it challenging for central banks to accurately measure and categorize the nominal money supply. New forms of digital payments, non-bank financial intermediaries, and liquid assets can blur the lines between different money aggregates, making traditional measures less comprehensive or precise.
• Endogenous Money Supply: Some economic theories argue that the money supply is largely "endogenous," meaning it is primarily determined by the demand for loans by businesses and individuals, rather than being solely controlled by the central bank. In this view, central banks primarily set interest rates, and the quantity of money adjusts to accommodate economic activity, rather than driving it.
• Policy Lags: There are significant and variable lags between changes in nominal money supply and their effects on the broader economy, making it difficult for policymakers to fine-tune interventions.
• Focus on Interest Rates: Many modern central banks, including the Federal Reserve, have shifted their primary focus from directly targeting money supply aggregates to managing short-term interest rates as their main tool for monetary policy, acknowledging the less predictable relationship between nominal money supply and ultimate economic goals.

These factors highlight that while the nominal money supply remains an important metric, it is viewed as just one piece of a complex puzzle in modern economic analysis and policymaking.

Nominal Money Supply vs. Real Money Supply

The distinction between nominal money supply and real money supply is crucial for understanding the true value and impact of money in an economy.

Nominal money supply refers to the absolute, unadjusted amount of money circulating in an economy at its face value. It is the sum of all physical currency and various forms of deposits, such as checking accounts and savings accounts. When economists or central banks refer to "M1" or "M2," they are typically discussing measures of nominal money supply. It reflects the quantity of monetary units available.

Real money supply, on the other hand, adjusts the nominal money supply for the effects of inflation. It represents the purchasing power of the money supply – what that quantity of money can actually buy in terms of goods and services. The real money supply is calculated by dividing the nominal money supply by a measure of the price level, such as the Consumer Price Index (CPI).

While the nominal money supply provides a snapshot of the volume of money, the real money supply gives a more accurate picture of the economic resources available to the public. For example, if the nominal money supply increases by 5% but inflation is 7%, the real money supply has actually decreased, meaning that the existing money can buy less than before.

FAQs

What are the main components of nominal money supply?

The main components of nominal money supply typically include physical currency (coins and paper money) in circulation and various types of bank deposits, such as checking accounts (demand deposits) and savings accounts. Broader measures also include less liquid assets like money market mutual funds and certificates of deposit.

How does a central bank control the nominal money supply?

A central bank influences the nominal money supply through its monetary policy tools. These tools include setting key interest rates (like the federal funds rate in the U.S.), conducting open market operations (buying or selling government securities), and adjusting reserve requirements for banks. By manipulating these tools, the central bank can inject or withdraw liquidity from the financial system, thereby expanding or contracting the nominal money supply.

Why is the nominal money supply important for the economy?

The nominal money supply is important because it represents the total pool of readily available funds for spending and investment in an economy. Its level and growth rate can influence inflation, interest rates, economic growth, and employment. Central banks monitor it as a key indicator to guide policies aimed at maintaining price stability and supporting economic activity.

Does an increase in nominal money supply always lead to inflation?

Not necessarily. While the quantity theory of money suggests a strong link between money supply growth and inflation, other factors can influence this relationship. The velocity of money (how quickly money changes hands) plays a significant role; if velocity declines, an increase in nominal money supply may not translate into higher prices. Additionally, increases in economic output (production of goods and services) can absorb more money without causing inflation.