Money supply is the aggregate amount of money circulating in the economy. Its measures vary among countries and typically include cash, coins, and balances in current and savings accounts.
Money supply measures and components
There is no absolute definition for “money” in the money supply calculation. The most common groupings are narrow money and broad money. Monetary authorities then break down them into several measures such as M0, M1, M2, M3, and M4.
In Indonesia, M1 is a narrow money and includes paper money, coins, and Rupiah-denominated demand deposits. Whereas M2 is the broad money, consisting of M1 plus quasi money (including savings, time deposits, and current accounts in foreign currencies), and securities issued by the monetary system owned by the domestic private sector with one-year-below maturity.
Another country might define M0 and M1 as the narrow money and typically include coins and notes in circulation plus other money equivalents that are readily convertible into cash. And M2 covers M1 plus short-term time deposits in banks and money market funds.
The link between money supply, inflation, and economic growth
The money supply has a substantial impact on the economy. Its change can affect inflation and economic growth.
Economists propose a concept of the quantity theory of money, which linking money supply and its circulation with inflation and aggregate output (real GDP).
The theory states that money supply times its velocity is equal to price and aggregate output.
M x V = P x Y
- M is the money supply
- V is the velocity of money (how many times the same money circulates in the economy)
- P is the general price level, and
- Y is the aggregate output.
The velocity of money does not change much from year to year. So, we can focus on the other three variables. For example, when the addition of the money supply (M) is much faster than the growth in the aggregate output (U), prices (P) will rise and create inflationary pressures in the economy. Or in other word, a higher increase in money supply than economic growth would result in upward pressure inflation.
Monetary policy to affect money supply
Monetary policy is an economic policy to influence the amount of money circulating in the economy. The process is through what economists call money creation.
Basically, contractionary monetary policy is to reduce the money supply, while expansionary monetary policy is to increase it. Both use the same instruments, namely policy rates, reserves requirement, and open market operations.
The adoption of monetary policy should be prudent. We can see in the equation of the quantity theory of money, where when the money supply increases, there are two possibilities, an increase in aggregate output or an increase in prices. The first is undoubtedly more desirable than the second.
Money creation process
Commercial banks play an essential role in the money creation process, especially under the current fractional reserve banking system. In this system, money is created every time a bank makes a new loan. A loan, when it is withdrawn and spent, will mostly end up as deposits in the banking system, which are counted as part of the money supply.
For a simple example, Bank ABC makes a new loan for its customers. The customers use the money to purchase cars from the seller. The seller gets the money and deposits it on Bank XYZ.
Then, after deducting for the reserve requirements, Bank XYZ uses the remaining money to make new loans for its customers. This process continues and creates a multiplier effect on the amount of money in circulation.
To calculate the magnitude of the multiplier effect of money, we can use the following formula:
Money multiplier = 1 / Reserve requirement ratio
For example, when the central bank sets a reserve requirement ratio of 20%, this means the bank must set aside 20% of deposits as mandatory reserves. The rest, 80% they can lend. So, for example, if someone saves Rp100 in Bank ABC, the amount of money will double to Rp500 (1/20%) through the money creation process.