Handling Your Money - Money Supply

In economics, money supply, or money stock, is the total amount of money available in an economy at a particular point in time. There are several ways to define "money", but each includes currency in circulation and demand deposits.

Money supply data is recorded and published in order to monitor the growth of the money supply. Public- and private-sector analysts have long monitored this growth because of the effects that it is believed to have on real economic activity and on the price level. The money supply is considered an important instrument for controlling inflation by those economists who say that growth in money supply will only lead to inflation if money demand is stable.

Because (in principle) money is anything that can be used in settlement of a debt, there are varying measures of money supply. Since most modern economic systems are regulated by governments through monetary policy, the supply of money is broken down into types of money based on how much of an effect monetary policy can have on that type of money. Narrow money is the type of money that is more easily affected by monetary policy whereas broad money is more difficult to affect through monetary policy. Narrow money exists in smaller quantities while broad money exists in much larger quantities. Each type of money can be classified by placing it along a spectrum between narrow and broad money. The different types of money are typically classified as Ms. The number of Ms usually range from M0 (narrowest) to M3 (broadest) but which Ms are actually used depends on the system. The typical layout for each of the Ms is as follows:

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 type 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:

central bank money (physical currency) commercial bank money (money created through loans) - sometimes referred to as checkbook money In the money supply statistics, central bank money is M0 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.

The Federal Reserve previously published data on three monetary aggregates, but now it only publishes data on 2 of them. The first, M1, is made up of types of money commonly used for payment, basically currency (M0) and checking deposits. 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. The third aggregate, M3, which is no longer published, 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 also includes 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:

M0: The total of all physical currency, plus accounts at the central bank that can be exchanged for physical currency.

M1: M0 - those portions of M0 held as reserves or vault cash + the amount in demand accounts ("checking" or "current" accounts).

M2: M1 + most savings accounts, money market accounts, and small denomination time deposits (certificates of deposit of under $100,000).

M3: M2 + all other CDs (large time deposits, institutional money market mutual fund balances), deposits of eurodollars and repurchase agreements.

The Federal Reserve ceased publishing M3 statistics in March 2006, claiming that M3 did not appear to convey additional information about economic activity compared to M2, had not been used in determining economic policy, and that the costs to collect M3 data outweighed the benefits. 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 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.". 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.

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 Certificate of Deposit.

European Union:

The Euro money supply from 1998-2007.The European Central Bank's definition of euro area monetary aggregates:

M1: Currency in circulation + overnight deposits

M2: M1 + Deposits with an agreed maturity up to 2 years + Deposits redeemable at a period of notice up to 3 months

M3: M2 + Repurchase agreements + Money market fund (MMF) shares/units + Debt securities up to 2 years

Australia:

The money supply of Australia 1984-2007The Reserve Bank of Australia defines the monetary aggregates as:

M1: currency + bank current deposits of the private non-bank sector

M3: M1 + all other bank deposits of the private non-bank sector

Broad Money: M3 + borrowings from the private sector by NBFIs, less the latter's holdings of currency and bank deposits

Money Base: holdings of notes and coins by the private sector plus deposits of banks with the Reserve Bank of Australia (RBA) and other RBA liabilities to the private non-bank sector.

New Zealand:

New Zealand money supply 1988-2008The Reserve Bank of New Zealand defines the monetary aggregates as:

M1: notes and coin held by the public plus chequeable deposits, minus inter-institutional chequeable deposits, and minus central government deposits

M2: M1 + all non-M1 call funding (call funding includes overnight money and funding on terms that can of right be broken without break penalties) minus inter-institutional non-M1 call funding

M3: the broadest monetary aggregate. It represents all New Zealand dollar funding of M3 institutions and any Reserve Bank repos with non-M3 institutions. M3 consists of notes & coin held by the public plus NZ dollar funding minus inter-M3 institutional claims and minus central government deposits

India:

Components of the money supply of India 1970-2007The Reserve Bank of India defines the monetary aggregates as:

Reserve Money (M0): Currency in circulation + Bankers’ deposits with the RBI + ‘Other’ deposits with the RBI = Net RBI credit to the Government + RBI credit to the commercial sector + RBI’s claims on banks + RBI’s net foreign assets + Government’s currency liabilities to the public – RBI’s net non-monetary liabilities.

M1: Currency with the public + Deposit money of the public (Demand deposits with the banking system + ‘Other’ deposits with the RBI).

M2: M1 + Savings deposits with Post office savings banks.

M3: M1+ Time deposits with the banking system. = Net bank credit to the Government + Bank credit to the commercial sector + Net foreign exchange assets of the banking sector + Government’s currency liabilities to the public – Net non-monetary liabilities of the banking sector (Other than Time Deposits).

M4: M3 + All deposits with post office savings banks (excluding National Savings Certificates).

Monetary exchange equation:

Money supply is important because it is linked to inflation by the "monetary exchange equation":
MV = PQ
• M is the total dollars in the nation’s money supply • V is the number of times per year each dollar is spent • P is the average price of all the goods and services sold during the year • Q is the quantity of goods and services sold during the year

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

nominal GDP = real 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).

Another aspect of money supply growth that has come under discussion since the collapse of the housing bubble in 2007 is the notion of "asset classes." Economists have noted that M3 growth may not affect all assets equally. For example, following the stock market run up and then decline in 2001, home prices began an historically unusual climb that then dropped sharply in 2007. The dilemma for the Federal Reserve in regulating the money supply is that lowering interest rates to slow price declines in one asset class, e.g. real estate, may cause prices in other asset classes to rise, e.g. commodities.

Bank Reserves at a 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. Note that while the terms "easing" and "tightening" are commonly used to describe the central bank's stated interest rate policy, a central bank has the ability to influence the money supply in a much more direct fashion, as explained earlier in this paragraph.

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 "multiplying" effect of the fractional-reserve system, 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 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. These loans can be bunched into securities and sold to somebody else, taking them off of the bank's books.

Therefore, neither commercial nor consumer loans are any longer limited by bank reserves. Since 1995 the amount of consumer loans has steadily increased, while bank reserves have generally remained constant:

References:

Paul M. Johnson. "Money stock:," A Glossary of Political Economy Terms

Alan Deardorff. "Money supply," Deardorff's Glossary of International Economics

Karl Brunner (1987), "money supply," The New Palgrave: A Dictionary of Economics, v. 3, p. 527.

The Money Supply - Federal Reserve Bank of New York

money supply Definition". Retrieved on 2008-07-20.

"M0". Investopedia. Retrieved on 2008-07-20.

"M1". Investopedia. Retrieved on 2008-07-20.

"M2". Investopedia. Retrieved on 2008-07-20.

"M2 Definition". InvestorWords.com. Retrieved on 2008-07-20.

"M3". Investopedia. Retrieved on 2008-07-20.

Bank for International Settlements - The Role of Central Bank Money in Payment Systems. See page 9, titled, "The coexistence of central and commercial bank monies: multiple issuers, one currency": http://www.bis.org/publ/cpss55.pdf A quick quote in reference to the 2 different types of money is listed on page 3. It is the first sentence of the document:

"Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies."

European Central Bank - Domestic payments in Euroland: commercial and central bank money: http://www.ecb.int/press/key/date/2000/html/sp001109_2.en.html One quote from the article referencing the two types of money:

At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time, this monopoly came to be shared with commercial banks, when deposits and their transfer via checks and giros became widely accepted. Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs. While transaction costs in commercial bank money were shrinking, cashless payment instruments became increasingly used, at the expense of banknotes"

Chicago Fed - Our Central Bank: http://www.chicagofed.org/consumer_information/the_fed_our_central_bank.cfm the reference is found in the "Money Manager" section:

the Fed works to control money at its source by affecting the ability of financial institutions to "create" checkbook money through loans or investments. The control lever that the Fed uses in this process is the "reserves" that banks and thrifts must hold."

ebook: The Federal Reserve - Purposes and Functions:http://www.federalreserve.gov/pf/pf.htm

What the Price of Gold Is Telling Us

Discontinuance of M3

Shadow Government Statistics

www.bankofengland.co.uk Explanatory Notes - M4 retrieved August 13 2007

The ECB's definition of euro area monetary aggregates: http://www.ecb.int/stats/money/aggregates/aggr/html/hist.en.html

RBA: Glossary - Text Only Version

Series description – Monetary and financial statistics

Handbook of Statistics on Indian Economy. See the document at the bottom of the page titled, "Notes on Tables". The link to this pdf document is: http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/80441.pdf The definitions are on the fourth page of the document

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

FRB: Speech, Bernanke-The Great Moderation-February 20, 2004

Wikipedia.org

A study into what exactly is "Money" and how to best handle it in todays world.

Money Supply