Money supply definition
The total amount of money in an economy at a given time is well known as money supply.
It is also an important instrument for controlling inflation by those economists who think that growth in money supply will only lead to inflation if money demand is stable. Regulators have to decide which particular measure of the money supply to target, in order to to control the money supply. It is more difficult to control that particular target, when the broader the targeted measure is. Targeting an unsuitable narrow money supply measure may lead to a situation where the total money supply in the country is not adequately controlled.
The money supply includes:
- Money in a building society
- Money in a savings account
- Money in a current account in the bank
- Notes and coins
Money functions
* It is a store of value e.g. it keeps its value
* It is a measure of value e.g. 1 mars bar = 40p
* It can be used as a means of exchange or to buy resources
Just to make the monitoring on the money supply easy, the nation’s central bank, the Federal Reserve System and controller of the monetary policy of the country, uses main four measures:
M1 - this is the base measurement of the money supply and includes: currency, coins, demand deposits, traveler’s checks from non-bank issuers, and other checkable deposits.
M2 is equal to M1 plus overnight repurchase agreements issued by commercial banks, overnight Eurodollars, money market mutual funds, money market deposit accounts, savings accounts, time deposits less than $100,000.
M3 is M2 plus institutionally held money market funds, term repurchase agreements, term Eurodollars, and large time deposits.
L - the fourth measure, is equal to M3 plus Treasury bills, commercial papers, bankers, acceptances, and very liquid assets such as savings bonds. In the UK the main measures of money supply are:
M0: Sterling notes and coins in circulation outside the Bank of England including those held in tills of banks and building societies plus banks’ operational deposits with the Bank of England. Also known as narrow money.
M4: M0 plus all sterling deposits at UK monetary financial institutions held in the M4 private sector. Also known as broad money.
As we know money is used in virtually all economic transactions and it has a powerful effect on economic activity, that’s why Money supply i so important. Increasing the supply of money helps consumers having more money in their hands, which making them feel wealthier, thus stimulating increased spending.
The same is and with the business firms, where they increase their sales by increasing production and ordering more raw materials. The spread of business activity increases the demand for labor and raises the demand for capital goods. Stock market prices rise and firms issue equity and debt - this is happening in a buoyant economy.
By increasing production and ordering more raw materials, most business firms respond to increased sales. The spread of business activity raises the demand for capital goods as well as increases the demand for labor. In a buoyant economy, stock market prices rise and firms issue equity and debt. Prices begin to rise, especially if output growth reaches capacity limits, when the money supply continues to expand. That’s something common. As the public begins to expect inflation, lenders insist on higher interest rates to offset an expected decline in purchasing power over the life of their loans.
When the the supply of money falls, or when its rate of growth declines - the opposite effects occur. Economic activity declines and either disinflation (reduced inflation) or deflation (falling prices) results. The Federal Reserve affects the money supply by affecting its most important component - bank deposits. Federal Reserve policy plays a main role in this - it is the most important determinant of the money supply.
The Federal Reserve uses open-market operations to either increase or decrease reserves. To increase reserves, the Federal Reserve buys U.S. Treasury securities by writing a check drawn on itself. The seller of the Treasury security deposits the check in a bank, increasing the seller’s deposit. The bank, in turn, deposits the Federal Reserve check at its district Federal Reserve bank, thus increasing its reserves. The opposite sequence occurs when the Federal Reserve sells Treasury securities: the purchaser’s deposits fall and, in turn, the bank’s reserves fall.
It requires commercial banks and other financial institutions to hold as reserves a fraction of the deposits they accept. Banks hold these reserves either as cash in their vaults or as deposits at Federal Reserve banks. In turn, the Federal Reserve controls reserves by lending money to banks and changing the “Federal Reserve discount rate” on these loans and by “open-market operations.“