What is one of the leading causes of inflation? What happens when you have too many dollars flowing into the economy? Who is in charge of printing US dollars? Can the US print as many dollars as it wants? You will be able to answer all these questions once you read our explanation of the money supply!
What is the Money Supply?
Money supply, in the simplest terms, is the total amount of money available in a country's economy at a particular time. It's like the financial 'blood supply' of the economy, encompassing all the cash, coins, and accessible deposits that individuals and businesses can use for spending or saving.
The money supply is defined as the total amount of currency and other liquid assets such as checkable bank deposits circulating in a country's economy. In most economies in the world, you have either the government or the central bank of a country in charge of the money supply. By increasing the money supply, these institutions provide more liquidity to the economy.
The Federal Reserve is the institution in charge of the money supply in the US. Using different monetary tools, the Federal Reserve ensures that the US economy's money supply is kept under control.
There are three main tools that the Federal Reserve uses to control the money supply in the economy:
To learn how these tools work in action, check our explanation on the Money Multiplier.
Money Supply Definition
Let's take a look at the definition of money supply:
The money supply refers to the aggregate amount of monetary assets available in a country at a specific time. It includes physical money such as coins and currency, demand deposits, savings accounts, and other highly liquid, short-term investments.
Money supply measurements, divided into four main aggregates - M0, M1, M2, and M3, reflect varying degrees of liquidity. M0 consists of physical currency in circulation and reserve balances, the most liquid assets. M1 includes M0 plus demand deposits, which can be directly used for transactions. M2 expands on M1 by adding less liquid assets like savings deposits, small-time deposits, and non-institutional money market funds. Finally, M3, the broadest measure, encompasses M2 and additional components like large-time deposits and short-term repurchase agreements, which can be readily converted into cash or checking deposits.
Fig 1. - Money supply and the monetary base
Figure 1 above shows the money supply and monetary base relationship.
Examples of Money Supply
Examples of money supply include:
- the amount of currency that circulates in the economy
- checkable bank deposits
You can think of money supply as any asset in the economy that can be converted into cash to make payments. However, there are different methods of measuring the money supply, and not all the assets are included.
To understand how the money supply is calculated and what it includes, check our explanation - Measures of Money Supply.
Banks and the Money Supply
Banks play an essential role when it comes to the money supply. An important distinction is that the Fed acts as a regulator while the banks carry out the regulations. In other words, the Fed's decision impacts banks, thereby impacting the money supply in an economy.
To learn more about the Fed, check our explanation on The Federal Reserve.
Banks influence the money supply by taking out of circulation money that sits in the hands of the public and putting them into deposits. For this, they pay interest on deposits. The deposited money has then been locked away and is not used for a pre-determined period in the agreement. As that money can't be used for making payments, it is not counted as part of the money supply in the economy. The Fed influences the interest that banks pay on deposits. The higher the interest rate they pay on deposits, the more individuals will be incentivized to put their money into deposits and therefore out of circulation, reducing the money supply.
Another important thing about banks and money supply is the process of money creation. When you deposit money in a bank, the bank keeps a portion of that money in their reserves to make sure they have enough money to give back to clients in case of withdrawal demands and use the rest of the money to make loans to other clients.
Let's assume that the client who borrowed from Bank 1 is named Lucy. Lucy then uses these borrowed funds and buys an iPhone from Bob. Bob uses the money he got from selling his iPhone to deposit them in another bank - Bank 2.
Bank 2 uses the deposited funds to make loans while keeping a portion of them in their reserves. This way, the banking system has created more money in the economy from the money Bob had deposited, thus increasing the money supply.
To learn about money creation in action, check our explanation on the Money Multiplier.
The portion of the funds that banks are required to keep in their reserves is determined by the Federal Reserve. Usually, the lower the amount of funds banks have to keep in their reserve, the higher the money supply in the economy is.
Money Supply Curve
What does the money supply curve look like? Let's take a look at Figure 2 below, showing the money supply curve. Notice that the money supply curve is a perfectly inelastic curve, which means that it is independent of the interest rate in the economy. That is because the Fed controls the amount of money supply in the economy. Only when there’s a change in the Fed's policy the money supply curve can shift either to the right or the left.
The money supply curve represents the relationship between the quantity of money supplied in the economy and the interest rate.
Figure 2. Money supply curve - StudySmarter Originals
Another important thing to notice here is that the interest rate is not solely dependent on the money supply but rather on the interaction of the money supply and the money demand. Holding money demand constant, changing the money supply will also change the equilibrium interest rate.
To better understand the changes in the equilibrium interest rate and how money demand and money supply interact in an economy, check our explanation - the Money Market.
Causes of Shifts in the Money Supply
The Federal Reserve controls the money supply, and there are three main tools it uses to cause a shift in the money supply curve. These tools include reserve requirement ratio, open market operations, and discount rate.
Figure 3. A shift in the money supply - StudySmarter Originals
Figure 3 shows a shift in the money supply curve. Holding money demand constant, a shift in the money supply curve to the right causes the equilibrium interest rate to drop and increases the amount of money in the economy. On the other hand, if the money supply shifted to the left, there would be less money in the economy, and the interest rate would rise.
To learn more about the factors that would cause the money demand curve to shift, see our article - Money Demand Curve
Money Supply: Reserve Requirement Ratio
The reserve requirement ratio refers to the funds that banks are obliged to keep in their reserves. When the Fed lowers the reserve requirement, banks have more money to lend to their clients as they need to keep less in their reserves. This then shifts the money supply curve to the right. On the other hand, when the Fed maintains a high reserve requirement, banks are obliged to keep more of their money in reserves, preventing them from making as many loans as they otherwise could. This shifts the money supply curve to the left.
Money Supply: Open Market Operations
Open market operations refer to the Federal Reserve's buying and selling of securities in the market. When the Fed buys securities from the market, more money is released into the economy, causing the money supply curve to shift to the right. On the other hand, when the Fed sells securities in the market, they withdraw the money from the economy, causing a leftward shift in the supply curve.
Money Supply: Discount Rate
The discount rate refers to the interest rate banks pay to the Federal Reserve for borrowing money from them. When the Fed increases the discount rate, it becomes more expensive for banks to borrow from the Fed. This then leads to a decrease in the money supply, which causes the money supply curve to shift to the left. Conversely, when the Fed decreases the discount rate, it becomes relatively cheaper for the banks to borrow money from the Fed. This results in a higher money supply in the economy, causing the money supply curve to shift rightward.
Effects of the Money Supply
Money supply has enormous effects on the U.S. economy. By controlling the money supply that circulates in the economy, the Fed can either increase inflation or keep it under control. Therefore, economists analyze the money supply and develop policies revolving around that analysis, which benefit the economy. It is necessary to conduct public and private sector studies to determine if the money supply influences price levels, inflation, or the economic cycle. When there is an economic cycle characterized by a rise in the price levels, such as the one we are experiencing currently in 2022, the Fed needs to step in and influence the money supply by controlling the interest rate.
When the quantity of money in the economy increases, interest rates tend to fall. This, in turn, leads to greater investment and more money in the hands of consumers, resulting in a boost in consumer spending. Businesses react by boosting their orders for raw materials and expanding their output. The higher level of commercial activity leads to a rise in the demand for workers.
On the other hand, when the money supply shrinks or when the pace of expansion of the money supply slows, there will be less employment, less output produced, and lower wages. That is due to the lower amount of money flowing into the economy, which could boost consumer spending and encourage businesses to produce more and hire more.
Changes in the money supply have long been recognized to be a significant determinant in the direction of macroeconomic performance and business cycles, and other economic indicators.
Positive Effect of Money Supply
To better understand the positive effects of the money supply, let us consider what happened during and after the 2008 Financial Crisis. During this period, there was a decline in the US economy, the sharpest decline since the Great Depression. Hence, some economists call it the Great Recession. During this period, many people lost their jobs. Businesses were shutting down as consumer spending dropped by a significant level. Housing prices were also collapsing, and the demand for houses was sharply down, resulting in significantly depressed aggregate demand and supply levels in the economy.
To tackle the recession, the Fed decided to increase the money supply in the economy. A few years later, consumer spending went up, which boosted the aggregate demand in the economy. As a result, businesses employed more people, producing more output, and the US economy got back on its feet.
Money Supply - Key takeaways
- The Money Supply is the sum of checkable or near checkable bank deposits plus currency in circulation.
- Money supply curve represents the relationship between the quantity of money supplied in the economy and the interest rate.
- By controlling the money supply circulating in the economy, the Fed can either increase inflation or keep it under control. Banks play an essential role when it comes to the money supply. An important distinction is that the Fed acts as a regulator while the banks carry out the regulations.
- When the money supply shrinks or when the pace of expansion of the money supply slows, there will be less employment, less output produced, and lower wages.
- There are three main tools that the Fed uses to cause a shift in the money supply curve. These are the reserve requirement ratio, open market operations, and discount rate.
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