Money Supply Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Money supply is the amount of money available for use in transactions. Money is an asset that is accepted by others as a medium of exchange for goods and services. Today, money in most countries is “fiat” money—money that has no commodity value and is legal tender by government decree. Goods and services are priced in terms of money, and money can be earned and used as a store of purchasing power and wealth. Globally the money supply is measured in a variety of ways, but most central banks consider the liquidity of assets—how easily an asset can be converted and used as money—when defining the money supply for the purpose of conducting policy.

Most central banks define the money supply using aggregates that vary from very narrow measures of the money supply to broad measures. These measures often have a name beginning with “M” and are usually defined based on the liquidity of the assets included. For example, the Bank of England uses M0 as their narrow definition of (most liquid) money. M0 includes notes and coin in circulation plus bank deposits with the Bank of England. In the United States, this narrow definition of money, currency plus bank reserves on deposit at the Federal Reserve Bank, is called the monetary base, or “high-powered money.” The next most liquid definition of money in the United States is M1, or currency held by the public plus checkable deposits at banks and travelers’ checks. Intermediate measures of money include assets that are less liquid, yet are easily converted to cash, such as various forms of savings and time deposits.

Central banks differ in their assessments of liquidity, based on who issues the asset, who holds the asset, how large the asset is, and how long the asset is held. This makes comparisons of monetary aggregates across countries difficult. For example, M2 in the United States includes all of M1 plus savings deposits, small-denomination time deposits, individually held money market mutual funds, overnight Eurodollars, and repurchase agreements. However, M2 in the European Economic and Monetary Union (EMU) is calculated by including M1 plus short-term savings and time deposits.

The Federal Reserve Bank in the United States no longer tracks M3, an even broader aggregate of the money supply focusing primarily on money held for its store of value; however, forms of M3 are measured in other countries such as the EMU, Canada, Japan, Mexico, and Korea. The Bank of England uses M4, one of the broadest measures of money, as one of its major monetary aggregates on which it bases monetary policy.

Measuring the money supply is important for central banks in the conduct of monetary policy. The money supply and its growth rate are key factors in determining an economy’s rate of inflation and short-term economic growth. A central bank influences the money supply when it prints money or increases bank reserves—most commonly through either the purchase of government securities or through low interest loans to banks, which, in turn, create money by extending loans to consumers. Too much money creation leads to higher levels of inflation; too little can lead to economic recession. This is summarized in the oft-cited equation of exchange:

% change in M + % change in V = % change in P + % change in Y

where the % change in M is the growth of the money supply, % change in V is the rate of change in the money supply’s velocity (number of times a unit of currency is used to conduct transactions), % change in P is inflation, and % change in Y is economic growth. Many theories of money assume that velocity is relatively stable, such that % change in V = 0. If we also assume that economic growth tends toward a specific and stable growth rate, then variations in the growth rate of the money supply above or below that growth rate show up predominantly through changes in inflation. Nobel Prize–winning economist Milton Friedman is often quoted for his assertion that “inflation is always and everywhere a monetary phenomenon.”

As reported in The Economist (August 11, 2007), it is usually common belief that central banks in the most developed countries control most of the world’s money supply growth. However, recent data show that three-fifths of the growth in the world’s money supply has come from emerging economies such as China, India, and Russia. Emerging economies have increased the growth rates of their money supplies by an average of 21 percent—almost three times the growth rates in developed economies. While the impact on developed economies of this growth (along with increasing global financial market integration) may not yet be fully understood, it is forcing central banks in developed countries to rethink the conduct of monetary policy.

Bibliography:

Ben Bernanke, “Globalization and Monetary Policy,” Fourth Economic Summit, Stanford Institute for Economic Policy Research (March 2, 2007);
Ibrahim Chowdry and Andreas Schabert, “Federal Reserve Policy Viewed Through a Money Supply Lens,” Journal of Monetary Economics (v.55/4, 2008);
Economist, “The Mandarins of Money,” The Economist (v.384/8541, 2007);
Milton Friedman and Anna Jacobson Schwartz, Monetary History of the United States 1867–1960 (Princeton University Press, 1980);
Jagdish Handa, Monetary Economics (Routledge, 2009);
Yueh-Yun O’Brien, Measurement of Monetary Aggregates Across Countries (Federal Reserve Board Finance and Economics Discussion Series, February 2007).

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