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Money supply
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In economics, money supply, or money stock, is the total amount of money available in an economy at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circulation and demand deposits.
Money supply data are recorded and published, usually by the government or the central bank of the country. Public- and private-sector analysts have long monitored changes in money supply because of its possible effects on the price level, inflation and the business cycle.
That relation between money and prices is historically associated with the quantity theory of money.
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Encyclopedia
In economics, money supply, or money stock, is the total amount of money available in an economy at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circulation and demand deposits.
Money supply data are recorded and published, usually by the government or the central bank of the country. Public- and private-sector analysts have long monitored changes in money supply because of its possible effects on the price level, inflation and the business cycle.
That relation between money and prices is historically associated with the quantity theory of money. There is strong empirical evidence of a direct empirical relation between long-term price inflation and money-supply growth. These underlie the current reliance on monetary policy as a means of controlling inflation.
Empirical measures
Money is used in final settlement of a debt and as a ready store of value. Its different functions are associated with different empirical measures of the money supply. Since most modern economic systems are regulated by governments through monetary policy, the supply of money is broken down into types of money based on how much of an effect monetary policy can have on each. Narrow measures include those more directly affected by monetary policy, whereas broader measures are less closely related to monetary-policy actions. Each measure can be classified by placing it along a spectrum between narrow and broad monetary aggregates. The different types of money are typically classified as Ms. The number of Ms usually range from M0 (narrowest) to M3 (broadest) but which Ms are actually used depends on the system. The typical layout for each of the Ms is as follows:
- M0: currency (notes and coins) in circulation and in bank vaults, plus reserves which commercial banks hold in their accounts with the central bank (minimum reserves and excess reserves). M0 is usually called the monetary base - the base from which other forms of money (like checking deposits, listed below) are created - and is traditionally the most liquid measure of the money supply.
- M1: currency in circulation + checkable deposits (checking deposits, officially called demand deposits, and other deposits that work like checking deposits) + traveler's checks. M1 represents the assets that strictly conform to the definition of money: assets that can be used to pay for a good or service or to repay debt. Although checks linked to checking deposits are gradually becoming less popular, debit cards linked to these deposits are becoming more popular. Like checks, debit cards, as a means to complete a transaction through their links to checkable deposits, can also be considered as a form of money.
- M2: M1 + savings deposits, time deposits less than $100,000 and money market deposit accounts for individuals. M2 represents money and "close substitutes" for money. M2 is a key economic indicator used to forecast inflation.
- M3: M2 + large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets. M3 is no longer measured by the US central bank.
Fractional-reserve banking
The different forms of money in government money supply statistics arise from the practice of fractional-reserve banking. Whenever a bank gives out a loan in a fractional-reserve banking system, a new type of money is created. This new type of money is what makes up the non-M0 components in the M1-M3 statistics. In short, there are two types of money in a fractional-reserve banking system:
- central bank money (physical currency, government money)
- commercial bank money (money created through loans) - sometimes referred to as private money, or checkbook money
In the money supply statistics, central bank money is M0 while the commercial bank money is divided up into the M1-M3 components. Generally, the types of commercial bank money that tend to be valued at lower amounts are classified in the narrow category of M1 while the types of commercial bank money that tend to exist in larger amounts are categorized in M2 and M3, with M3 having the largest.
Money supplies around the world
United States
The Federal Reserve previously published data on three monetary aggregates, but on 10 November 2005 announced that as of 23 March 2006, it would cease publication of M3. Since the Spring of 2006, the Federal Reserve only publishes data on two of these aggregates. The first, M1, is made up of types of money commonly used for payment, basically currency (M0) and checking deposits. The second, M2, includes M1 plus balances that generally are similar to transaction accounts and that, for the most part, can be converted fairly readily to M1 with little or no loss of principal. The M2 measure is thought to be held primarily by households. The third aggregate, M3 is no longer published. Prior to this discontinuation, M3 had included M2 plus certain accounts that are held by entities other than individuals and are issued by banks and thrift institutions to augment M2-type balances in meeting credit demands; it had also included balances in money market mutual funds held by institutional investors. The aggregates have had different roles in monetary policy as their reliability as guides has changed. The following details their principal components:
- M0: The total of all physical currency, plus accounts at the central bank that can be exchanged for physical currency.
- M1: The total of all physical currency part of bank reserves + the amount in demand accounts ("checking" or "current" accounts).
- M2: M1 + most savings accounts, money market accounts, retail money market mutual funds,and small denomination time deposits (certificates of deposit of under $100,000).
- M3: M2 + all other CDs (large time deposits, institutional money market mutual fund balances), deposits of eurodollars and repurchase agreements.
When the Federal Reserve announced in 2005 that they would cease publishing M3 statistics in March 2006, they explained that M3 did not convey any additional information about economic activity compared to M2, and thus, had not been used in determining monetary policy for years. Therefore, the costs to collect M3 data outweighed the benefits the data provided. Some politicians have spoken out against the Federal Reserve's decision to cease publishing M3 statistics and have urged the U.S. Congress to take steps requiring the Federal Reserve to do so. Congressman Ron Paul claimed that "M3 is the best description of how quickly the Fed is creating new money and credit. Common sense tells us that a government central bank creating new money out of thin air depreciates the value of each dollar in circulation." Some of the data used to calculate M3 are still collected and published on a regular basis. Current alternate sources of M3 data are available from the private sector.
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 Certificate of Deposit.
There are several different definitions of money supply to reflect the differing stores of money. Due to the nature of bank deposits, especially time-restricted savings account deposits, the M4 represents the most illiquid measure of money. M0, by contrast, is the most liquid measure of the money supply.
European Union
The European Central Bank's definition of euro area monetary aggregates:
- M1: Currency in circulation + overnight deposits
- M2: M1 + Deposits with an agreed maturity up to 2 years + Deposits redeemable at a period of notice up to 3 months
- M3: M2 + Repurchase agreements + Money market fund (MMF) shares/units + Debt securities up to 2 years
Australia
The Reserve Bank of Australia defines the monetary aggregates as:
- M1: currency + bank current deposits of the private non-bank sector
- M3: M1 + all other bank deposits of the private non-bank sector
- Broad Money: M3 + borrowings from the private sector by NBFIs, less the latter's holdings of currency and bank deposits
- Money Base: holdings of notes and coins by the private sector plus deposits of banks with the Reserve Bank of Australia (RBA) and other RBA liabilities to the private non-bank sector
New Zealand
The Reserve Bank of New Zealand defines the monetary aggregates as:
- M1: notes and coins held by the public plus chequeable deposits, minus inter-institutional chequeable deposits, and minus central government deposits
- M2: M1 + all non-M1 call funding (call funding includes overnight money and funding on terms that can of right be broken without break penalties) minus inter-institutional non-M1 call funding
- M3: the broadest monetary aggregate. It represents all New Zealand dollar funding of M3 institutions and any Reserve Bank repos with non-M3 institutions. M3 consists of notes & coin held by the public plus NZ dollar funding minus inter-M3 institutional claims and minus central government deposits
India
The Reserve Bank of India defines the monetary aggregates as:
- Reserve Money (M0): Currency in circulation + Bankers’ deposits with the RBI + ‘Other’ deposits with the RBI = Net RBI credit to the Government + RBI credit to the commercial sector + RBI’s claims on banks + RBI’s net foreign assets + Government’s currency liabilities to the public – RBI’s net non-monetary liabilities.
- M1: Currency with the public + Deposit money of the public (Demand deposits with the banking system + ‘Other’ deposits with the RBI).
- M2: M1 + Savings deposits with Post office savings banks.
- M3: M1+ Time deposits with the banking system. = Net bank credit to the Government + Bank credit to the commercial sector + Net foreign exchange assets of the banking sector + Government’s currency liabilities to the public – Net non-monetary liabilities of the banking sector (Other than Time Deposits).
- M4: M3 + All deposits with post office savings banks (excluding National Savings Certificates).
Japan
The Bank of Japan defines the monetary aggregates as:
- M1: cash currency in circulation + deposit money
- M2 + CDs: M1 + quasi-money + CDs
- M3 + CDs: (M2 + CDs) + deposits of post offices + other savings and deposits with financial institutions + money trusts
- Broadly-defined liquidity: (M3 + CDs) + pecuniary trusts other than money trusts + investment trusts + bank debentures + commercial paper issued by financial institutions + repurchase agreements and securities lending with cash collateral + government bonds + foreign bonds
Link with inflation
Monetary exchange equation
Money supply is important because it is linked to inflation by the equation of exchange:
MV = PQ
• M is the total dollars in the nation’s money supply
• V is the number of times per year each dollar is spent
• P is the average price of all the goods and services sold during the year
• Q is the quantity of assets, goods and services sold during the year
where:
- velocity = the number of times per year that money turns over in transactions for goods and services (if it is a number it is always simply nominal GDP / money supply)
- nominal GDP = real Gross Domestic Product × GDP deflator
- GDP deflator = measure of inflation.
The quantity of assets goods and service sold during the year could be grossly estimated by GDP back in the 1960s. This is not the case anymore because of the rise of financial transactions relative to real transaction.
Money supply may be less than or greater than the demand of money in the economy. If the money supply grows faster than its use, inflation in a class of goods or assets is likely to follow (according to Milton Friedman, "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.
Economists have noted that M3 growth may not affect all assets or goods equally. For example, an almost constant rise in M3 in the 1970s, '80s and '90s produced a rise in consumer goods prices "inflation" in the seventies and a rise in the stock market in the '80s and '90s and a rise in home prices after 2001.
When home prices went down, the Federal Reserve kept its loose monetary policy and lowered interest rates; the attempt to slow price declines in one asset class, e.g. real estate, may well have caused prices in other asset classes to rise, e.g. commodities.
Percentage
In terms of percentage changes (to a small approximation, , 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).
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. Note that while the terms "easing" and "tightening" are commonly used to describe the central bank's stated interest rate policy, a central bank has the ability to influence the money supply in a much more direct fashion, as explained earlier in this paragraph.
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 "multiplying" effect of the fractional-reserve system, 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 funds, which require no reserves. Then in the early 1990s, reserve requirements were dropped to zero on savings deposits, CDs, and Eurodollar deposit. 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 are not limited by bank reserves. Most 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.
Therefore, neither commercial nor consumer loans are any longer limited by bank reserves. Since 1995 the amount of consumer loans has steadily increased:
In recent years, the irrelevance of open market operations has also been argued by academic economists renowned 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
The main functions of the central bank are to maintain low inflation, and full employment. The U.S. Central bank may attempt to do this by artificially stimulating demand by affecting the nation's money supply via lower (or higher) interest rates. Furthermore, deficit spending on the authorization of the U.S. Government is designed to artificially stimulate aggregate demand for products and services within an economy.
Another means, of stimulating demand would be changes in both consumption taxes, and personal income taxes. The argument for either, as per the efficiency to which the additional dollars are being utilized, would determine their overall effect on the GDP of a nation, and whether or not a sustainable stimulus is in effect. For example, a dollar given to a tax-payer (tax credit) for purchases of products or services (stimulating monetary velocity), versus a dollar given to an additional construction laborer - infrastructure redevelopment (for example, also stimulating monetary velocity).
The main debate amongst economists in the second half of the twentieth century concerned the central banks ability to predict how much money should be in circulation, given current employment rates, and inflation rates. Some economists like Milton Friedman believed that the central bank would always get it wrong, leading to wider swings in the economy than if it were just left alone. This is why they advocated a non-interventionist approach.
Chairman of the U.S. Federal Reserve, Ben Bernanke, has suggested that over the last 10 to 15 years, many modern central banks have become relatively adept at manipulation of the money supply, leading to a smoother business cycle, with recessions tending to be smaller and less frequent than in earlier decades, a phenomenon he terms "The Great Moderation" However these assumptions may very well prove ill-conceived by the ongoing financial/economic crisis of 2008-present. History will judge whether or not the now classical thinking of interest, and money supply moderation, have proven effective in preventing recessions, severe or mild. Furthermore, it may be that the functions of the central bank may need to encompass more than the 'jigging' up or down of interest rates in order to influence money supply, in the sense that these tools, although valuable, do not in fact control the very volatility, nor directly the velocity, of money supply in a nation's economy.
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