Money supply

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Money supply ("monetary aggregates", "money stock"), a macroeconomic concept, is the quantity of money available within the economy to purchase goods, services, and securities. The money supply affects the interest rates. The two are related inversely, such that, as money supply increases interest rates will fall. When the interest rate equates the quantity of money demanded with the quantity of money supply, the economy is working at the money market equilibrium.

Contents

[edit] Introduction

The monetary sector, as opposed to the real sector, concerns the money demand market. The same tools of analysis can be applied as to other markets: supply and demand result in an equilibrium price, where the free market (or long term) interest rate plus the quantity of real money available balances the demand for money. Short term rates are artificially manipulated by the Federal Reserve in the open market.

When thinking about the "supply" of money, it is natural to think of the total of banknotes and coins in an economy. That, however, is vastly incomplete. In the United States, coins are minted by the United States Mint, part of the Department of the Treasury, outside of the Federal Reserve. Banknotes are printed by the Bureau of Engraving & Printing on behalf of the Federal Reserve as symbolic tokens of electronic, credit-based money that has already been created or more precisely, issued by private banks[1] through fractional reserve banking.

In this respect, all paper banknotes in existence are systematically linked to the expansion of the electronic, credit-based money supply. Coinage can be increased or decreased outside this system by Legal Mandate or Legislative Acts. However, at present the coin base is held in check and used as a complementary system rather than a competitive system with private bank issue of electronic, credit-based money. The common practice is to include printed and minted money supply in the same metric M0.

The more accurate starting point for the concept of money supply is the total of all electronic, credit-based deposit balances in bank (and other financial) accounts (for more precise definitions, see below) plus all the minted coins and printed paper. The M1 money supply is M0, plus the total of (non-paper or coin) deposit balances without any withdrawal restrictions (restricted accounts that you can't write checks on are put in the next level of liquidity, M2).

The relationship between the M0 and M1 money supplies is the money multiplier — basically, the ratio of cash and coin in people's wallets and bank vaults and ATMs to Total balances in their financial accounts. The gap and lag between the two (M0 and M1 - M0) occurs because of the system of fractional reserve banking.

[edit] Scope

Because (in principle) money is anything that can be used in settlement of a debt, there are varying measures of money supply. The narrowest (i.e., most restrictive) measures count only those forms of money available for immediate transactions, while broader measures include money held as a store of value

[edit] United States

U.S. Money Supply from 1959-2006
U.S. Money Supply from 1959-2006

The most common measures are named M0 (narrowest), M1, M2, and M3. In the United States they are defined by the Federal Reserve as follows:

As of March 23, 2006, information regarding M3 will no longer be published by the Federal Reserve. The other three money supply measures will continue to be provided in detail. On March 7th, 2006, Congressman Ron Paul introduced H.R. 4892 in an effort to reverse this change.[2]

[edit] 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 CDs.v

[edit] Link with inflation

[edit] Monetary exchange equation

Money supply is important because it is linked to inflation by the "monetary exchange equation":

\textrm{velocity} \times \textrm{money\ supply} = \textrm{real\ GDP} \times \textrm{GDP\ deflator}

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)
  • real GDP = nominal 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).

U.S. M3 money supply as a proportion of gross domestic product.
U.S. M3 money supply as a proportion of gross domestic product.

[edit] Percentage

(excerpted from "Breaking Monetary Policy into Pieces", May 24 2004, http://www.hussmanfunds.com/wmc/wmc040524.htm)

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).

[edit] Money supply and cash

In the U.S., as of December, 2006, M1 was about $1.37 trillion and M2 was about $7.02 trillion. If you split all of the money equally per person in the United States, each person would end up with roughly $4,550 ($1,370,000M/301M) using M1 or $23,320 ($7,020,000M/301M) using M2. The amount of actual physical cash, M0, was $800 billion in 2006, roughly three times the $261 billion in cash and cash equivalents on deposit at Citigroup as of the end of that year and roughly $2,658 per person in the US. [3] [4]

[edit] The central bank

The United States supply of money, outside of coins minted by the United States Mint, can increase only if the private banks issue more by loaning into circulation through fractional reserve bank lending practices. Subsequently paper notes are increased only as they are printed by the BEP on behalf of the banking system and are swapped at par value by the Federal Reserve with private banks for their already issued electronic credits, which are then expunged from the system by the Federal Reserve. Thus, these printed notes merely replace already issued electronic credits on a one-for-one basis.

The larger definitions of the money supply, M1, M2, and M3, are types of deposit accounts. The first balance sheet item in a bank is usually deposits. Of the money in a bank deposit, depending on reserve requirements, either the whole sum or some fraction of it can immediately be lent out. The borrower can buy an asset and the seller of that asset can place the proceeds in another money supply constituent deposit. The money supply has just increased, because both the original and secondary deposits count as part of the money supply. That money can therefore continue to increase many times over. The Federal Reserve decides the level of "reserves of depository institutions".

Monetary policy has effects on employment and output in the short run, but in the long run, it primarily affects prices.

[edit] The balance sheets

This is what money supply growth may look like starting with 1 new dollar of deposits. The money is moving from left to right. The Central Bank injects money from its reserve into the economy by buying a government bond from Bank 1 for $1, Bank 1 lends the proceeds to Person 1, who buys an asset from Person 2, who deposits the proceeds at Bank 2, who loans it to Person 3, who buys a service from Person 4, who deposits the proceeds in Bank 1, and the money supply becomes $2.[5]

Central Bank
Assets
Gov. debt (to B1) $1
Liabilities
- -
Bank 1
Assets
Loan (to P1) $1
Liabilities
Deposit (from P4) $1
Person 1
Assets
Investment (to P2) $1
Liabilities
Loan (from B1) $1
Person 2
Assets
Deposit (to B2) $1
Liabilities
- -
Bank 2
Assets
Loan (to P3) $1
Liabilities
Deposit (from P2) $1
Person 3
Assets
- -
Liabilities
Loan (from B2) $1
Person 4
Assets
Deposit (to B1) $1
Liabilities
- -

[edit] 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.

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 magic of the "money multiplier", 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 market funds, which require no reserves. Then in the early 1990s, reserve requirements were dropped to zero on savings deposits, CDs, and Eurocurrency deposits. 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 have nothing to do with bank reserves and in effect create what is known as "moral hazard" and speculative bubble economies.

These days, 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.

The point is simple. Commercial, industrial and consumer loans no longer have any link to bank reserves. Since 1995, the volume of such loans has exploded, while bank reserves have declined.

In recent years, the irrelevance of open market operations has also been argued by academic economists renown 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.

[edit] Arguments and criticism

One of the principal jobs of central banks (such as the Federal Reserve, the Bank of Canada, and the European Central Bank) is to keep money supply growth in line with real GDP growth. Central banks do this primarily by targeting some inter-bank interest rate (in the U.S., this is the federal funds rate) through open market operations.

A very common criticism of this policy, originating with the creators of GDP as a measure[citation needed], is that "real GDP growth" is in fact meaningless, and since GDP can grow for many reasons including manmade disasters and crises, is not correlated with any known means of measuring well-being. This use of the GDP figures is argued to be an abuse, and dangerous[citation needed]. The most common solution proposed by such critics is that money supply (which determines the value of all financial capital, ultimately, by diluting it) should be kept in line with some more ecological and social and human means of measuring well-being. In theory, money supply would expand when well-being is improving, and contract when well-being is decreasing, giving all parties in the economy a direct interest in improving well-being.

This argument must be balanced against what is nearly dogma among economists: that the control of inflation within a certain range is the main (or only) job of a central bank, and that any introduction of non-financial means of measuring well-being has an inevitable domino effect of increasing government spending and diluting capital and the rewards of gainfully employing capital.

Currency integration is thought by some economists -- Robert Mundell, for example -- to alleviate this problem by ensuring that currencies become less competitive in the commodity markets, and that a wider political base be employed in the setting of currency and inflation and well-being policy. This thinking is in part the basis of the Euro currency integration in the European Union.

Some economists argue for the money supply to remain constant at all times. With growth in production, this would result in falling prices. A constant money supply will keep nominal incomes constant over time. However, falling prices will lead to an increase in real incomes.

[edit] See also

[edit] Notes and references

  1. ^ The term private bank is here used as a bank that is not government owned, not as a bank for high net worth individuals.
  2. ^ H.R.4892 at thomas.loc.gov
  3. ^ http://www.federalreserve.gov/releases/h6/current/
  4. ^ http://www.citigroup.com/citigroup/fin/data/k04c_restated.pdf
  5. ^ See, for example, the balance sheet from Citigroup Inc. at http://www.citigroup.com/citigroup/fin/ar.htm

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