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 each includes currency in circulation and demand deposits.

Money supply data are recorded and published. Public- and private-sector analysts have long monitored changes in money supply because of its possible effects on the price level and the nominal or real value of output.[1] That relation is historically associated with the quantity theory of money and evidence of a direct empirical relation between long-term price inflation and money-supply growth. These underlie reliance on monetary policy as a means of controlling inflation.[2]

Contents

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.[2] 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. [3]
  • 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.[4]
  • 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. [5] M2 is a key economic indicator used to forecast inflation.[6]
  • 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.[7]

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[8][9]:

  1. central bank money (physical currency)
  2. commercial bank money (money created through loans) - sometimes referred to as checkbook money[10]

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.[11] 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[12]:

  • 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, 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.[11] 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."[13] Some of the data used to calculate M3 are still collected and published on a regular basis.[11] Current alternate sources of M3 data are available from the private sector[14].

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 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.

Money supply may be less than or greater than the demand of money in the economy. In other words, if the money supply grows faster than real GDP growth (described as "unproductive debt expansion"), inflation is likely to follow ("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 (which is to be expected due to the increase in population, unless money supply grows very rapidly).

Another aspect of money supply growth that has come under discussion since the collapse of the housing bubble in 2007 is the notion of "asset classes." Economists have noted that M3 growth may not affect all assets equally. For example, following the stock market run up and then decline in 2001, home prices began an historically unusual climb that then dropped sharply in 2007. The dilemma for the Federal Reserve in regulating the money supply is that lowering interest rates to slow price declines in one asset class, e.g. real estate, may cause prices in other asset classes to rise, e.g. commodities.

Percentage

In terms of percentage changes (to a small approximation, the percentage change in a product, 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).[15]

See also

Notes

  1. ↑ The Money Supply - Federal Reserve Bank of New York
  2. ↑ 2.0 2.1 "money supply Definition". Retrieved on 2008-07-20.
  3. ↑ "M0". Investopedia. Retrieved on 2008-07-20.
  4. ↑ "M1". Investopedia. Retrieved on 2008-07-20.
  5. ↑ "M2". Investopedia. Retrieved on 2008-07-20.
  6. ↑ "M2 Definition". InvestorWords.com. Retrieved on 2008-07-20.
  7. ↑ "M3". Investopedia. Retrieved on 2008-07-20.
  8. ↑ Bank for International Settlements - The Role of Central Bank Money in Payment Systems. See page 9, titled, "The coexistence of central and commercial bank monies: multiple issuers, one currency": http://www.bis.org/publ/cpss55.pdf A quick quote in reference to the 2 different types of money is listed on page 3. It is the first sentence of the document:
    "Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies."
  9. ↑ European Central Bank - Domestic payments in Euroland: commercial and central bank money: http://www.ecb.int/press/key/date/2000/html/sp001109_2.en.html One quote from the article referencing the two types of money:
    "At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time, this monopoly came to be shared with commercial banks, when deposits and their transfer via checks and giros became widely accepted. Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs. While transaction costs in commercial bank money were shrinking, cashless payment instruments became increasingly used, at the expense of banknotes"
  10. ↑ Chicago Fed - Our Central Bank: http://www.chicagofed.org/consumer_information/the_fed_our_central_bank.cfm
    the reference is found in the "Money Manager" section:
    "the Fed works to control money at its source by affecting the ability of financial institutions to "create" checkbook money through loans or investments. The control lever that the Fed uses in this process is the "reserves" that banks and thrifts must hold."
  11. ↑ 11.0 11.1 11.2 Discontinuance of M3, Federal Reserve, November 10, 2005, revised March 9, 2006.
  12. ↑ ebook: The Federal Reserve - Purposes and Functions:http://www.federalreserve.gov/pf/pf.htm
  13. ↑ What the Price of Gold Is Telling Us
  14. ↑ See, for example, [1]
  15. ↑ "Breaking Monetary Policy into Pieces", May 24 2004, http://www.hussmanfunds.com/wmc/wmc040524.htm

External links

Data

Articles

Computer simulations

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