Money supply

Money supply ("monetary aggregates", "money stock"), a macroeconomic concept, is the quantity of money available within the economy to purchase goods, services, and securities. Because (in principle) money is anything that can be used in settlement of a debt, there are varying measures of money supply. The narrowest (ie. more restrictive) measures count only those forms of money held for immediate transactions.

Broader measures include money held as a store of value. Different measures of money have different technical definitions. The most common measures are named M0, M1, M2, and M3 (from narrow to broadly defined). In the United States, these are defined as follows:

• M0: The total of all coins and paper cash in circulation.
• M1: M0 + the amount in checking or demand deposit accounts
• M2: M1 + other various savings account types, money market accounts, and certificate of deposit accounts (CDs) of under $100,000.
• M3: M2 + all other CDs and eurodollar deposits and repos.

Link with inflation

Money supply is important because it is directly linked to inflation by the "monetary exchange equation":

 velocity * money supply = real GDP * GDP deflator

where:

• velocity = the number of times per year that money changes hands (if it's a number it's always simply GDP / money supply)
• GDP (Gross Domestic Product) deflator = measure of inflation

Or PY = MV. P (the price level) times Y (real output) equal M (money stock) times V ("velocity"). ([1] (http://www.hussmanfunds.com/wmc/wmc040524.htm))

In other words, if the money supply grows faster than real GDP, inflation must follow as velocity has been shown to be relatively stable.

In terms of percentage changes (to a small approximation, the percentage change in a product, say XY is equal to the sum of the percentage changes %X + %Y). So:

%P + %Y = %M + %V

That equation rearranged gives the "basic inflation identity":

%P = %M + %V - %Y

Inflation (%P) is equal to the rate of money growth (%M), plus the change in velocity (%V), minus the rate of output growth (%Y).

Money Supply and Cash

As of about the year 2000, the M1 money supply was about 1.3 trillion dollars, the M2 was $5.4 trillion, and the M3 was $7.8 trillion. If you split all of the money equally per person in the United States, each person would end up with about 26,000.

The amount of actual physical cash was about half a trillion as of the year 2000. To put this in perspective, if everyone who had liabilities at the largest US bank Citigroup tried to liquidate all of their assets from there, there would not be enough cash. ([2] (http://finance.yahoo.com/q/bs?s=C&annual))

The Central Bank

The supply of money can only increase if the money is first "printed" by the issuer of money, usually the government central bank. The central bank "prints" coins and bills and electronic money.

The "printing" is usually done with the central bank buying government debt. The government debt can be bought directly from the government or from public holdings (primarily banks). In the United States the decision on how much government debt the Federal Reserve should buy is decided by the Federal Open Market Committee (FOMC).

The big chunk of the money supply, M1, M2, and M3, are types of deposit accounts. The first balance sheet item in a bank is usually deposits. If $1 end up as a deposit in a bank (bank liability), depending on what "reserve requirements" that deposit has, the whole sum or almost the whole sum can immediately be lent out. If the deposit has no reserve requirement the whole dollar can be lent out, and the borrower can buy an asset, and the seller of the asset can place the proceeds in another money supply constituent deposit. And the money supply is now $2 or close to $2. That money can then in theory continue to increase many times over.

The Federal Reserve decides the level of "reserves of depository institutions".

Monetary policy has significant effects on employment and output in the short run, but in the long run, it affects primarily prices.

The balance sheets

This is what money supply growth may look like starting with 1 new dollar of deposits. The money is moving from left to right. The Central Bank buys a government bond from Bank 1 for $1, Bank 1 lends the proceeds to Person 1, who buy an asset from Person 2, who deposit the proceeds at Bank 2, who loans it to Person 3, who buys an asset from Person 4, who deposit the proceeds in Bank 1, and the money supply is $2.

See for example the balance sheet from Citigroup Inc. at [3] (http://www.citigroup.com/citigroup/fin/ar.htm).

Bank reserves at Central Bank

When the Fed is "easing", it increases the monetary base by purchasing Treasuries on the open market. When the Fed is "tightening", it reduces the monetary base by selling Treasuries on the open market. It reduce or increase the supply of short term government debt, and inversely increase or reduce the supply of currency.

The operative notion of easy money is that the Fed creates new bank reserves (also known as "federal funds", trades in the "money market"), 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 magic of the "money multiplier", loans and bank deposits go up by many times the initial injection of reserves.

However in the 1970s the reserve requrements 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 Eurocurrency deposits. At present, reserve requirements apply only to "transactions deposits" - essentially checking accounts. The vast majority of funding sources used by banks to create loans have nothing to do with bank reserves.

These days, commercial and industrial loans are financed by issuing large denomination CDs. Money market deposits are largely used to lend to corporations who issue short term 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.

The point is simple. Commercial, industrial and consumer loans no longer have any link to bank reserves. Since 1995, the volume of such loans has exploded, while bank reserves have declined.

In recent years, the irrelevance of "open market operations" has also been argued (for slightly different reasons) by academic economists renown for their work in the theory of “rational expectations”, including Thomas Sargent and John Muth.

Arguments and criticism

One of the principal jobs of central banks (such as the US Federal Reserve, the Bank of England and the European Central Bank) is to keep money supply growth in line with real GDP growth. Central banks do this primarily by applying pressure on the "federal funds" interest rate through open market operations.

A very common criticism of this policy, originating with the creators of GDP as a measure, is that "real GDP growth" is in fact meaningless, and since GDP can grow for many reasons including manmade disasters and crises, is not correlated with any known means of measuring well-being. This use of the GDP figures is considered by its own creators to be an abuse, and dangerous. The most common solution proposed by such critics is that money supply (which determines the value of all financial capital, ultimately, by diluting it) should be kept in line with some more ecological and social and human means of measuring well-being. In theory, money supply would expand when well-being is improving, and contract when well-being is decreasing, giving all parties in the economy a direct interest in improving well-being.

This argument must be balanced against the near-dogma among economists, that the control of inflation is the main (or only) job of a central bank, and that any introduction of non-financial means of measuring well-being has an inevitable domino effect of increasing government spending and diluting capital and the rewards of gainfully employing capital.

Currency integration is thought by some economists -- Robert Mundell, for example -- to alleviate this problem by ensuring that currencies become less competitive in the commodity markets, and that a wider political base be employed in the setting of currency and inflation and well-being policy. This thinking is in part the basis of the Euro currency integration in the European Union.

Money supply remains one of the most controversial aspects of economics itself.

United States Money Supply

United States money supply at the end of September 2004. The only deposits that have "reserve requirements" are the M1 "checking deposits".

1. Currency outside U.S. Treasury, Federal Reserve Banks and the vaults of depository institutions.

2. Demand deposits at domestically chartered commercial banks, U.S. branches and agencies of foreign banks, and Edge Act corporations (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float.

3. NOW and ATS balances.

4. Savings deposits include money market deposit accounts.

5. Small-denomination time deposits are those issued in amounts of less than $100,000. All IRA and Keogh account balances at commercial banks and thrift institutions are subtracted from small time deposits.

6. IRA and Keogh account balances at money market mutual funds are subtracted from retail money funds.

7. Large-denomination time deposits at domestically chartered commercial banks, U.S. branches and agencies of foreign banks, and Edge Act corporations, excluding those amounts held by depository institutions, the U.S. government, foreign banks and official institutions, and money market mutual funds.

8. RP liabilities of depository institutions, in denominations of $100,000 or more, on U.S. government and federal agency securities, excluding those amounts held by depository institutions, the U.S. government, foreign banks and official institutions, and money market mutual funds.

9. Eurodollars held by U.S. addressees at foreign branches of U.S. banks worldwide and at all banking offices in the United Kingdom and Canada, excluding those amounts held by depository institutions, the U.S. government, foreign banks and official institutions, and by money market mutual funds.

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