What Exactly Is the Money Supply? 16 comments
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What is meant by the term money supply? The term itself implies that a certain amount of money exists at any given time, even though the quantity may be unknown. In truth there can be no meaningful measure of the quantity because it is continually varying as a function of demand.
The Fed has its own arbitrary measures of the money supply, which it once used to help guide its monetary policy decisions. It defines money as the total of cash in circulation and deposit liabilities of banks and thrifts. At one time it set targets for the growth of the money supply. Now it largely ignores its own measures because it has found little correlation between them and its major policy objectives – limiting inflation and unemployment.
Monetary Aggregates
The Fed has defined three monetary aggregates M1, M2, and M3. The narrowest definition, M1, includes the transaction deposits of banks and cash in circulation. M2 adds savings accounts, small time deposits at banks, and retail money market funds. M3 adds large time deposits, repurchase agreements, Eurodollars, and institutional money market funds. In March 2006 the Fed discontinued tracking M3 because it does not convey information about economic activity that is not already embodied in M2.
Note that the Fed's definition of the money supply includes only what the non-bank sector holds. Thus the reserves of banks, i.e. vault cash and deposits at the Fed, though a part of the monetary base, are not included in the monetary aggregates. That means when a bank spends for itself, it increases the money supply. When it receives payments from the public such as interest on loans, the money supply decreases.
Bank Lines of Credit as a Money Equivalent
An important shortcoming of the Fed's definition is that it ignores lines of credit which can be exercised at the discretion of the borrower. Firms often hold substantial lines of credit from their banks, which they can use on short notice. Likewise consumers hold lines of credit in their credit card accounts that are just as useful for purchases as checking accounts or the currency in their wallets. Lines of credit increase liquidity, which is ultimately what counts in terms of enhancing aggregate demand.
When someone uses a credit card in a purchase, he or she automatically expands the money supply. The seller receives a new deposit in his account, which increases the total of demand deposits in the banking system -- until the buyer pays off the loan. The result is that consumers who roll over their credit card loans rather than paying them off have increased the money supply on their own initiative by hundreds of billions of dollars. In effect, the money supply is substantially larger and less measurable than the Fed's definition.
The Quantity Theory of Money
Economists regularly use the term money supply without defining it. A notable example is the equation of exchange in the quantity theory of money.
MV = PT
This relates the money supply, M, and the velocity of money, V, to the average price level, P, and the total number of transactions, T, in a given time period. The equation is simply an identity, meaning it is true by definition. Yet it is often used to "prove" that the average price level increases with the quantity of money. An identity says nothing about causal relations. The only thing we know is the product MV, which equals the national income, PT, which itself is only roughly measurable. The quantity of money, M, remains undefined and unknowable.
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Thanks for some fuller knowledge here.
I suppose the govt is paying for more of its deficit now by printing money instead of borrowing, to keep the money supply steady.
It's seen as a better gauge of money supply because it reflects (zero maturity) money that is immediately available for consumption. And, I would estimate a lot of credit is not available for immediate consumption. Hence, no inflation, yet.
Here's a nice link...a bit dated.
www.zealllc.com/2002/m...
Now------------what is meant by 'money supply' ?
I've never come across a convincing explanation of any one of the symbols in that equation. The term "Money supply" shares a characteristic with most concepts in economics - it promises an explanatory theory and prescription for policy but actually delivers nothing.
Like much of Keynesianism it provides a lot of technocats and political opportunists with convenient cover for pretending to know what they're talking about.
blogs.cfr.org/setser/
On Dec 19 12:59 PM morph man wrote:
> The formula MV=PT is one of the least helpful in a supposed science
> that has most of the qualities of a medieval superstition.
> I've never come across a convincing explanation of any one of the
> symbols in that equation. The term "Money supply" shares a characteristic
> with most concepts in economics - it promises an explanatory theory
> and prescription for policy but actually delivers nothing.
> Like much of Keynesianism it provides a lot of technocats and political
> opportunists with convenient cover for pretending to know what they're
> talking about.
The money supply as defined by the Fed, the three Ms, is so incomplete that the Fed itself doesn't use those aggregates any more as indicators of future inflation.
On Dec 19 06:48 AM Alan von Altendorf wrote:
> Unknowable. Can't even see it in Statistical Abstract of the US as
> a tabular series. Banks don't have balance sheets. Jeez.
On Dec 19 10:08 AM BLITZ wrote:
> Thanks, I couldn't remember what those 3ms stood for and it sounds
> as if the total money supply is still in reality unknown.
On Dec 19 07:59 AM GeorgeS wrote:
> Surely increasing money increases demand and then prices.
> Thanks for some fuller knowledge here.
> I suppose the govt is paying for more of its deficit now by printing
> money instead of borrowing, to keep the money supply steady.
I appreciate the point about credit. in the late 1970s inflation increased for a while faster than M1. I attributed that to the rise of Visa and Mastercard. Then there seemed to be a year or so when Velocity increased, without M1. But generally the correlation between M1 and inflation worked. Now with combination checking/savings accounts it became harder again. That's the story in a nutshell since the 1970s. In the early 1980s the Fed understood this and succeeded in taming inflation.
On Dec 22 11:10 PM William Hummel wrote:
> In a modern credit money economy, the money supply increases or decreases
> as a function of prices rather than vice versa for the most part.
>
The monetarist view applies to a cash economy, but there are no such economies today except in primitive societies. Bank credit normally arises as a result of a decision to buy, e.g. home loans, auto loans, etc. Those decision are not driven by the existence of too much credit money, although very low interest rates can grease the sale. Therefore it is up to the Fed to control the interest rate levels to prevent easy credit money from being the cause of price increases. When it fails to do so, price inflation most often occurs in assets, seldom in consumer goods and services.
On Dec 24 08:20 AM GeorgeS wrote:
> You are trying to strike at the heart of monetarism. Monetarism is a truism, and there can't be doubt that adding money increases general demand.
(Is anyone else following this thread anymore?)
On Dec 24 05:25 PM William Hummel wrote:
> The fault-line of monetarism is that it presumes to know cause and
> effect. Money drives prices is an axiom needing no proof. It is
> true that the general price level and the amount of credit money
> outstanding are correlated, but correlation says nothing about causation.
>
>
> The monetarist view applies to a cash economy, but there are no such
> economies today except in primitive societies. Bank credit normally
> arises as a result of a decision to buy, e.g. home loans, auto loans,
> etc. Those decision are not driven by the existence of too much
> credit money, although very low interest rates can grease the sale.
> Therefore it is up to the Fed to control the interest rate levels
> to prevent easy credit money from being the cause of price increases.
> When it fails to do so, price inflation most often occurs in assets,
> seldom in consumer goods and services.
>
The Fed's most basic component of the money supply (M1) is defined by the Fed as "Currency outside the U.S. Treasury, Federal Reserve Banks and the vaults of depository institutions", plus checkable deposits.
Currency outside the Fed and Treasury is reasonable, but I have misgivings about excluding ALL the currency in vaults of banks. Apparently they view private banks as essentially extensions of the government currency distribution system. That makes sense, but only to the extent that currency in the vaults is counterbalanced by a liability to the Fed.
In other words, if the Fed sends a bank $10 million in fresh new bills, and so the bank's account at the Fed is debited for the $10 million, the new vault assets are completely offset by a debt to the Fed. At this point it is reasonable to say the money is not yet "in the economy" (M1) since the bank has zero equity in the $10 million - it is 100% owed to the Fed.
But what about bank's vault holdings beyond its debt to the Fed? Surely that should count as money supply in M1, since the bank owns it free and clear. Or suppose an business has a large need for cash, so its local bank has learned to keep lots of extra currency on hand for this customer, in the vault. On pure technicality, this currency would be excluded from the definition of the money supply, though it belonged to, and was being used in the economy by a customer.