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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.
Imagine it as the lifeblood of the economy, constantly circulating and facilitating transactions. This money supply encompasses everything from the bills in your wallet to the digital balances in your checking and savings accounts.
Why is money supply important?
The money supply plays a crucial role in shaping the economic landscape. It can impact two key factors:
- Inflation: A rapid increase in the money supply can lead to inflation, which means the overall price of goods and services rises. Think of it as having too much money chasing after a limited amount of goods, driving prices up.
- Economic growth: On the other hand, a controlled increase in the money supply can stimulate economic growth. By making more money available, businesses can invest and expand, potentially leading to more jobs and production.
What is measured in the money supply?
The money supply encompasses various types of money, but there’s no single universally accepted definition. Different countries might categorize things slightly differently. Here’s a breakdown of the most common classifications:
The no-single-definition dilemma:
Imagine trying to define “money” definitively. Is it just the cash in your wallet? What about your checking account balance? Economists acknowledge this complexity. The money supply considers various assets that can be used to pay for goods and services, not just physical cash.
The two main categories
The money supply is typically categorized into two broad groups:
Narrow money (M1): This is the most liquid form of money, readily available for spending. It often includes:
- Physical cash (coins and bills)
- Checking account balances
- Demand deposits (money in your checking account that you can withdraw anytime without notice)
Broad money (M2): This category includes M1, plus less liquid assets that can be easily converted to cash. Examples might include:
- Savings account balances
- Money market accounts (interest-bearing accounts that allow a limited number of withdrawals per month)
Beyond M1 and M2
Some countries define even broader categories:
- M3: This might encompass M2 plus even less liquid assets like certificates of deposit (CDs) with a maturity period of less than one year.
- M4: This could include all of the above, plus even less-liquid assets like large time deposits and bonds.
Global Variations
Keep in mind that specific definitions for M0, M1, M2, etc., can vary by country. For example, some countries might include savings accounts in M1, while others classify them under M2.
The key takeaway is that the money supply represents a spectrum of financial assets used for transactions, with narrow money being the most liquid and readily spendable. The following sections will explore how these categories relate to economic factors like inflation and growth.
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 links it 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
Where:
- 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.
Imagine the money supply (M) as a fixed amount of water in a pool. The velocity (V) is like the speed at which the water circulates. If the water moves slowly (low V), it won’t reach everyone as quickly. Aggregate output (Y) is like the size of the pool. A larger pool can hold more water without overflowing.
Money supply and inflation:
The key concept is that an increase in money supply (M) can lead to inflation (P) if it’s not matched by a similar increase in aggregate output (Y).
Think back to our pool analogy. If you add more water (M) to a fixed-size pool (Y) without increasing circulation (V), the water level (prices – P) will rise. This is essentially what happens with inflation.
When the money supply grows faster than output:
If the money supply increases much faster than the production of goods and services (M growth > Y growth), there’s more money chasing the same amount of goods. This can drive prices up (inflation) because businesses can raise prices knowing there’s more money in circulation.
It’s not always perfect: It’s important to note that the Quantity Theory is a simplified model. Velocity (V) isn’t constant and can be influenced by factors like consumer confidence. However, it provides a valuable framework for understanding the connection between money supply and inflation.
How central banks affect money supply (monetary policy)
Central banks play a critical role in managing the money supply through a set of tools known as monetary policy. This policy aims to achieve economic goals like price stability and sustainable growth. Let’s delve into how central banks influence the money supply:
- Contractionary policy: This aims to reduce the money supply when inflation is a concern. By tightening the money supply, central banks aim to slow down economic activity and prevent prices from rising too fast.
- Expansionary policy: Conversely, this aims to increase the money supply during economic slowdowns. By making more money available, central banks hope to stimulate borrowing, investment, and spending, ultimately boosting economic growth.
Monetary policy instruments
Central banks have a toolkit of instruments to implement monetary policy and influence the money supply:
- Policy rates: This is the central bank’s benchmark interest rate, which influences borrowing costs throughout the economy. Lowering rates encourages borrowing and spending while raising rates discourages them.
- Reserve requirements: This is the amount of money banks must hold in reserve as a percentage of deposits. Increasing reserve requirements reduces the amount of money banks can lend, effectively shrinking the money supply.
- Open market operations (OMO): This involves the central bank buying or selling government bonds in the open market. When the central bank buys bonds, it injects money into the economy, expanding the money supply. Conversely, selling bonds removes money from circulation.
Choosing the right policy
The decision to use a contractionary or expansionary policy requires careful consideration. Central banks must weigh the risk of inflation against the need for economic growth. Ideally, they want to see an increase in aggregate output (Y) alongside a controlled increase in the money supply (M) to avoid inflation (P).
Money creation process by commercial banks
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 in Bank XYZ.
Then, after deducting from 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%, 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.
