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In economics, the money supply or money stock, is the total amount of monetary assets available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits (depositors' easily accessed assets on the books of financial institutions).
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 effects on the price level, inflation, the exchange rate 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 relation between money-supply growth and long-term price inflation, at least for rapid increases in the amount of money in the economy. For example, a country such as Zimbabwe which saw extremely rapid increases in its money supply also saw extremely rapid increases in prices (hyperinflation). This is one reason for the reliance on monetary policy as a means of controlling inflation.
The nature of this causal chain is the subject of contention. Some heterodox economists argue that the money supply is endogenous (determined by the workings of the economy, not by the central bank) and that the sources of inflation must be found in the distributional structure of the economy.
In addition, those economists seeing the central bank's control over the money supply as feeble say that there are two weak links between the growth of the money supply and the inflation rate. First, in the aftermath of a recession, when many resources are underutilized, an increase in the money supply can cause a sustained increase in real production instead of inflation. Second, if the velocity of money, i.e., the ratio between nominal GDP and money supply changes, an increase in the money supply could have either no effect, an exaggerated effect, or an unpredictable effect on the growth of nominal GDP.
Money is used as a medium of exchange, a unit of account, and as a ready store of value. Its different functions are associated with different empirical measures of the money supply. There is no single "correct" measure of the money supply. Instead, there are several measures, classified along a spectrum or continuum between narrow and broad monetary aggregates. Narrow measures include only the most liquid assets, the ones most easily used to spend (currency, checkable deposits). Broader measures add less liquid types of assets (certificates of deposit, etc.).
This continuum corresponds to the way that different types of money are more or less controlled by monetary policy. Narrow measures include those more directly affected and controlled by monetary policy, whereas broader measures are less closely related to monetary-policy actions. It is a matter of perennial debate as to whether narrower or broader versions of the money supply have a more predictable link to nominal GDP.
The different types of money are typically classified as "M"s. The "M"s usually range from M0 (narrowest) to M3 (broadest) but which "M"s are actually focused on in policy formulation depends on the country's central bank. The typical layout for each of the "M"s is as follows:
|Type of money||M0||MB||M1||M2||M3||MZM|
|Notes and coins in circulation (outside Federal Reserve Banks and the vaults of depository institutions) (currency)||✓||✓||✓||✓||✓||✓|
|Notes and coins in bank vaults (Vault Cash)||✓|
|Federal Reserve Bank credit (required reserves and excess reserves not physically present in banks)||✓|
|Traveler's checks of non-bank issuers||✓||✓||✓||✓|
|Other checkable deposits (OCDs), which consist primarily of Negotiable Order of Withdrawal (NOW) accounts at depository institutions and credit union share draft accounts.||✓||✓||✓||✓|
|Time deposits less than $100,000 and money-market deposit accounts for individuals||✓||✓|
|Large time deposits, institutional money market funds, short-term repurchase and other larger liquid assets||✓|
|All money market funds||✓|
The ratio of a pair of these measures, most often M2 / M0, is called an (actual, empirical) money multiplier.
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 sum 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:
In the money supply statistics, central bank money is MB 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.
In the US, reserves consist of money in Federal Reserve accounts and US currency held by banks (also known as "vault cash"). Currency and money in Fed accounts are interchangeable (both are obligations of the Fed.) Reserves may come from any source, including the federal funds market, deposits by the public, and borrowing from the Fed itself.
A reserve requirement is a ratio a bank must maintain between deposits and reserves. Reserve requirements do not apply to the amount of money a bank may lend out. The ratio that applies to bank lending is its capital requirement.
Note: The examples apply when read in sequential order.
The Federal Reserve previously published data on three monetary aggregates, but on November 10, 2005 announced that as of March 23, 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 account balances. 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. As mentioned, 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:
It should be noted that while the treasury can and does hold cash and a special deposit account at the Fed (fed funds), these assets do not count in any of the aggregates. So in essence taxes paid to the Federal Government (Treasury) is excluded from the money supply. To counter this, the government created the TT&L program in which any receipts above a certain threshold are redeposited in private banks. The idea is that tax receipts won't decrease the amount of reserves in the banking system. The TT&L accounts, while demand deposits, do not count toward M1 or any other aggregate as well.
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, "has not played a role in the monetary policy process for many 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 (R-TX) 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." Modern Monetary Theory disagrees. It holds that money creation in a free-floating fiat currency regime such as the U.S. will not lead to significant inflation unless the economy is approaching full employment and full capacity. 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.
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.
In 1967, when sterling was devalued, the dollar's peg to the pound was increased from 1 shilling 3 pence to 1 shilling 4½ pence (14.5455 dollars = 1 pound) although this did not entirely offset the devaluation. In 1972, the Hong Kong dollar was pegged to the U.S. dollar at a rate of 5.65 H.K. dollar = 1 U.S. dollar. This was revised to 5.085 H.K. dollar = 1 U.S. dollar in 1973. Between 1974 and 1983, the Hong Kong dollar was floated. On 17 October 1983, the currency was pegged at a rate of 7.8 H.K. dollar = 1 U.S. dollar, through the currency board system. As of 18 May 2005, in addition to the lower guaranteed limit, a new upper guaranteed limit was set for the Hong Kong dollar at 7.75 to the American dollar. The lower limit has been lowered from 7.80 to 7.85 (by 100 pips per week from 23 May to 20 June 2005). The Hong Kong Monetary Authority indicated this move is to narrow the gap between the interest rates in Hong Kong and those of the United States. A further aim of allowing the Hong Kong dollar to trade in a range is to avoid the HK dollar being used as a proxy for speculative bets on a renminbi revaluation. The Basic Law of Hong Kong and the Sino-British Joint Declaration provides that Hong Kong retains full autonomy with respect to currency issuance. Currency in Hong Kong is issued by the government and three local banks under the supervision of the territory's de facto central bank, the Hong Kong Monetary Authority. Bank notes are printed by Hong Kong Note Printing Limited. A bank can issue a Hong Kong dollar only if it has the equivalent exchange in US dollars on deposit. The currency board system ensures that Hong Kong's entire monetary base is backed with US dollars at the linked exchange rate. The resources for the backing are kept in Hong Kong's exchange fund, which is among the largest official reserves in the world. Hong Kong also has huge deposits of US dollars, with official foreign currency reserves of 331.3 billion USD as of September 2014.
In mathematical terms, this equation is really an identity which is true by definition rather than describing economic behavior. That is, each term is defined by the values of the other three. Unlike the other terms, the velocity of money has no independent measure and can only be estimated by dividing PQ by M. Some adherents of the quantity theory of money assume that the velocity of money is stable and predictable, being determined mostly by financial institutions. If that assumption is valid then changes in M can be used to predict changes in PQ. If not, then a model of V is required in order for the equation of exchange to be useful as a macroeconomics model or as a predictor of prices.
Most macroeconomists replace the equation of exchange with equations for the demand for money which describe more regular and predictable economic behavior. However, predictability (or the lack thereof) of the velocity of money is equivalent to predictability (or the lack thereof) of the demand for money (since in equilibrium real money demand is simply Q/V). Either way, this unpredictability made policy-makers at the Federal Reserve rely less on the money supply in steering the U.S.economy. Instead, the policy focus has shifted to interest rates such as the fed funds rate.
In practice, macroeconomists almost always use real GDP to measure Q, omitting the role of all transactions except for those involving newly produced goods and services (i.e., consumption goods, investment goods, government-purchased goods, and exports). That is, the only assets counted as part of Q are newly produced investment goods. But the original quantity theory of money did not follow this practice: PQ was the monetary value of all new transactions, whether of real goods and services or of paper assets.
The monetary value of assets, goods, and service sold during the year could be grossly estimated using nominal GDP back in the 1960s. This is not the case anymore because of the dramatic rise of the number of financial transactions relative to that of real transactions up until 2008. That is, the total value of transactions (including purchases of paper assets) rose relative to nominal GDP (which excludes those purchases).
Ignoring the effects of monetary growth on real purchases and velocity, this suggests that the growth of the money supply may cause different kinds of inflation at different times. For example, rises in the U.S. money supplies between the 1970s and the present encouraged first a rise in the inflation rate for newly produced goods and services ("inflation" as usually defined) in the seventies and then asset-price inflation in later decades: it may have encouraged a stock market boom in the '80s and '90s and then, after 2001, a rise in home prices, i.e., the famous housing bubble. This story, of course, assumes that the amounts of money were the causes of these different types of inflation rather than being endogenous results of the economy's dynamics.
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. commoditie.s
In terms of percentage changes (to a close approximation under small growth rates, the percentage change in a product, say XY, is equal to the sum of the percentage changes %ΔX + %ΔY). So:
That equation rearranged gives the "basic inflation identity":
Inflation (%ΔP) is equal to the rate of money growth (%ΔM), plus the change in velocity (%ΔV), minus the rate of output growth (%ΔQ). As before, this equation is only useful if %ΔV follows regular behavior. It also loses usefulness if the central bank lacks control over %ΔM.
|The examples and perspective in this section may not represent a worldwide view of the subject. (June 2010)|
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 the amount of bank reserves and the monetary base rise. By purchasing government bonds (e.g., U.S. Treasury bills), this bids up their prices, so that interest rates fall at the same time that the monetary base increases.
With "easy money," the central bank creates new bank reserves (in the US known as "federal funds"), which allow the banks lend more. 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.
In contrast, 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. By increasing the supply of bonds, this lowers their prices and raises interest rates at the same time that the money supply is reduced.
This kind of policy reduces or increases the supply of short term government debt in the hands of banks and the non-bank public, lowering or raising interest rates. In parallel, it increases or reduces the supply of loanable funds (money) and thereby the ability of private banks to issue new money through issuing debt.
The simple connection between monetary policy and monetary aggregates such as M1 and M2 changed in the 1970s as 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, for example in Canada, 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. This means that instead of the amount of loans supplied responding passively to monetary policy, we often see it rising and falling with the demand for funds and the willingness of banks to lend.
Some academics argue that the money multiplier is a meaningless concept, because its relevance would require that the money supply be exogenous, i.e. determined by the monetary authorities via open market operations. If central banks usually target the shortest-term interest rate (as their policy instrument) then this leads to the money supply being endogenous.
|This article is outdated. (March 2009)|
Neither commercial nor consumer loans are any longer limited by bank reserves. Nor are they directly linked proportional to reserves. Between 1995 and 2008, the amount of consumer loans has steadily increased out of proportion to bank reserves. Then, as part of the financial crisis, bank reserves rose dramatically as new loans shrank.
In recent years, some academic economists renowned for their work on the implications of rational expectations have argued that open market operations are irrelevant. These include Robert Lucas, Jr., Thomas Sargent, Neil Wallace, Finn E. Kydland, Edward C. Prescott and Scott Freeman. The Keynesian side points to a major example of ineffectiveness of open market operations encountered in 2008 in the United States, when short-term interest rates went as low as they could go in nominal terms, so that no more monetary stimulus could occur. This zero bound problem has been called the liquidity trap or "pushing on a string" (the pusher being the central bank and the string being the real economy).
The main functions of the central bank are to maintain low inflation and a low level of unemployment, although these goals are sometimes in conflict (according to Phillips curve). A central bank may attempt to do this by artificially influencing the demand for goods by increasing or decreasing the nation's money supply (relative to trend), which lowers or raises interest rates, which stimulates or restrains spending on goods and services.
An important debate among economists in the second half of the twentieth century concerned the central bank's ability to predict how much money should be in circulation, given current employment rates and inflation rates. Economists such as 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—one of targeting a pre-specified path for the money supply independent of current economic conditions— even though in practice this might involve regular intervention with open market operations (or other monetary-policy tools) to keep the money supply on target.
The former Chairman of the U.S. Federal Reserve, Ben Bernanke, suggested in 2004 that over the preceding 10 to 15 years, many modern central banks became 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 termed "The Great Moderation" This theory encountered criticism during the global financial crisis of 2008–2009. Furthermore, it may be that the functions of the central bank may need to encompass more than the shifting up or down of interest rates or bank reserves: these tools, although valuable, may not in fact moderate the volatility of money supply (or its velocity).