MEASURING MONEY

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What is Money Supply?

Money supply in an economy is the total volume of currency in circulation at a particular point in time. It can include cash and its equivalents like currency notes, coins, and bank deposits. It is a critical concept that greatly impacts a country’s financial and economic situation.





Key Takeaways

  • The money supply denotes the total amount of cash and cash equivalents in a country.
  • The central bank in a country monitors the supply situation through monetary policies, which can be expansionary or contractionary, based on its objectives.
  • Important determinants of money circulation and supply are high-powered money, level of commercial bank reserves, reserve ratio, and liquid cash held by the public. 
  • The monetary base is a highly liquid form of money, which includes currency notes, coins, and commercial bank reserves

Money Supply Explained

Money supply is a very important financial indicator and affects the economy in many ways. Therefore, the government and the central bank closely watch the money circulation in an economy. Thus, it should be optimum, neither high nor less. 

An increase in the supply implies that people are spending more, which increases the demand for products and services in the economy. As a result, high demand contributes to a rise in prices. Therefore, the high circulation of money will lead to higher inflation rates.

In such situations, the central banks will introduce a monetary policy to reduce consumer spending. It is usually done by increasing interest rates on consumer loans. Hence, customers will stop borrowing and have to cut down on spending. Thus, it reduces money circulation.

However, prolonged periods of reduced supply are also equally harmful. If customers give up spending altogether, the economy will become stagnant, leading to mass unemployment. Therefore, the government will introduce an expansionary monetary policy, where the interest rates on borrowing will be decreased. As a result, people will borrow more and spend more. Central banks also inject additional money into the economy. Most governments keep the money circulation and supply records public, and anyone can access them. 

Measurement

Since the supply of money is an important economic parameter, governments constantly monitor and regulate it. Therefore, they measure the amount of money frequently to keep it in check. Standard measures of money supply include M1, M2, M3, and M4. 

The measurement of the supply begins with the M0 or monetary base. It denotes the amount of currency in circulation, i.e., currency bills, coins, and bank reserves.

  • M1 money supply: Also called the ‘narrow money,’ it includes M0 and other highly liquid deposits in the bank.
  • M2 money supply: It is perhaps the most commonly accepted measure because it consists of M1 in addition to marketable securities and less liquid deposits. 
  • M3 money supply: Known as ‘broad money,’ it constitutes M2 and money market funds like mutual funds, repurchase agreements, commercial papers, etc.
  • M4 money supply: It comprises M3 and all other least liquid assets, usually outside commercial bank.

Thus, the above types of money supply measurements and their formulas can be summarized as follows:

M0 = Currency notes + coins + bank reserves

M1 = M0 + demand deposits

M2 = M1 + marketable securities + other less liquid bank deposits

M3 = M2 + money market funds

M4 = M3 + least liquid assets

These measures of money supply usually vary depending on the country. For example, the Federal Reserve usually focuses on M1 and M2 types to monitor the U.S. money supply, whereas the Bank of England measures M4 types too. 






Determinants of Money Supply

There are many aspects to the circulation of money in a country. One such aspect is the determinants, which help influence and accurately quantify an economy’s supply situation.

  1. High-powered money – Cash and its equivalents available with the public and bank deposits are included in high-powered money. Since they are highly liquid, they directly affect the supply of money in an economy.
  2. Level of commercial bank reserves – The central bank mandates commercial banks to hold a fixed percentage of deposits as reserves in case of any emergency. Banks lend the excess reserves amount to consumers, increasing money circulation.
  3. Reserve ratio – It is the ratio of cash reserve to deposits, as instructed by the central bank. If the central bank increases the ratio, banks will have to hold more money in reserves, reducing banks’ lending capabilities.
  4. Liquid cash held by the public – If the people have more liquid cash at home, they will only spend a small portion required. However, if the same cash is deposited in the bank, the supply in the economy will be high.

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