Money Supply

Refers to the entire amount of cash and other liquid assets in an economy on a given day.

Author: Kevin Henderson
Kevin Henderson
Kevin Henderson
Private Equity | Corporate Finance

Kevin is currently the Head of Execution and a Vice President at Ion Pacific, a merchant bank and asset manager based Hong Kong that invests in the technology sector globally. Prior to joining Ion Pacific, Kevin was a Vice President at Accordion Partners, a consulting firm that works with management teams at portfolio companies of leading private equity firms.

Previously, he was an Associate in the Power, Energy, and Infrastructure Investment Banking group at Lazard in New York where he completed numerous M&A transactions and advised corporate clients on a range of financial and strategic issues. Kevin began his career in corporate finance roles at Enbridge Inc. in Canada. During his time at Enbridge Kevin worked across the finance function gaining experience in treasury, corporate planning, and investor relations.

Kevin holds an MBA from Harvard Business School, a Bachelor of Commerce Degree from Queen's University and is a CFA Charterholder.

Reviewed By: Elliot Meade
Elliot Meade
Elliot Meade
Private Equity | Investment Banking

Elliot currently works as a Private Equity Associate at Greenridge Investment Partners, a middle market fund based in Austin, TX. He was previously an Analyst in Piper Jaffray's Leveraged Finance group, working across all industry verticals on LBOs, acquisition financings, refinancings, and recapitalizations. Prior to Piper Jaffray, he spent 2 years at Citi in the Leveraged Finance Credit Portfolio group focused on origination and ongoing credit monitoring of outstanding loans and was also a member of the Columbia recruiting committee for the Investment Banking Division for incoming summer and full-time analysts.

Elliot has a Bachelor of Arts in Business Management from Columbia University.

Last Updated:November 8, 2023

What Is the Money Supply?

Money supply (MS) refers to the entire amount of cash and other liquid assets in an economy on a given day. This includes all checkable bank deposits circulating at a given time.

The central bank and country leaders hold the most power, as they can cause the most change in the money supply. The economic decisions they make for their country determine how much money will be circulating.

They do this using many methods, like making new policies, as they try their best to maintain a healthy economy. For example, in America, the Federal Reserve has a job to prevent the economy from losing power, and they do that by using different monetary policies.

They also continuously observe this supply every month, which needs to be repeatedly tracked, so they don't risk any possible economic issues.

Key Takeaways

  • Money supply (MS) is the total amount of cash and other liquid assets circulating in the economy, such as bank check deposits.
  • The MS gives us a good general idea of how a country performs, as a state's economy is usually a good indicator of a country’s performance.
  • The federal reserve is responsible for tracking and controlling the MS and making the necessary changes to stabilize the economy. 
  • An increase in MS can be good, as it can mean the economy is performing well and there is more overall money circulation.
  • Too much MS has a negative effect, such that it decreases the value of a country’s currency, leading to uncontrollable inflation.
  • Contractionary and expansionary monetary policies are the main and most effective policies used to increase or decrease the MS.
  • Out of all money aggregates, M1 and M2 are the most useful aggregates when reporting and updating the public on the financial situation of their economy.

Understanding Money Supply

The MS gives us a good overall picture of how a country is performing, as a state's economy is most likely a good indicator of a country’s success or lack of success.

The reason behind this is simple: The MS of a country is affected by any movement in the interest and inflation rates, which are pivotal factors in any given economy.

Regarding inflation, having a lot of money circulating among people is not necessarily good. So one of the things the Fed works on is limiting the money supply if we have an excess MS problem.

Having too much money circulating could bring the value of a country’s currency down. This, as a result, can make most goods and supplies more expensive, negatively impacting most consumers.

With that said, there are times when the Fed has no choice but to increase the MS because they need to improve the economy if it is not performing well. This is done by increasing money circulation, which increases consumption and benefits the economy.

Role of Banks in Money Supply

It is important to understand how the overall MS of an economy and banks go hand in hand. It is the actions that banks perform that change the MS of an economy.

Banks can increase the money supply by collecting and supplying some of the money they receive. Anytime a bank gets a hold of some cash from a customer, they will take out a portion of that money and keep it as reserves.

This money in reserves is kept there in case the client needs them sometime in the future to make a payment. In addition, loan payments affect the overall MS of the economy.

Apart from the portion of the money they keep in reserves, banks keep some of the money for customers that need a loan. So, as you can see, this circular and continuous process goes on, which summarizes the relationship between banks and the money supply.

This circular process consists of the banks retrieving the money a customer deposits, taking out a portion, and saving it if the customer needs to withdraw some of it later. Finally, the rest of the money is used to give out loans to other customers.

Therefore, banks conduct this process to increase the MS because the money being loaned out increases circulation among the public, and this process keeps repeating itself.

Example

Let’s look at an example to make more sense:

Suppose we have a customer named Joseph. Joseph decides to visit a furniture store to buy a new couch. He finds what he wants and pays $2,000 for that new couch.

What happens here is that the store owner, Patrick, collects the money and deposits it into his bank account. Let’s call it Bank 1. Next, Bank 1 will keep some of this money in reserves.

For simple calculations, let’s assume that the Federal Reserve requires banks to keep 50% of customer deposits as reserves.

This means that Bank 1 will put aside $1,000 (50% of $2,000) as reserves for Patrick. Then, anytime Patrick needs to withdraw cash to make a purchase; he will take money out of his reserves.

For the rest of the money, Bank 1 will use them as loans for other customers who need some cash. For example, a random customer collects some of the money provided as a loan and uses it to spend money in a clothing shop.

The shop owner will collect the money and place it in his deposits in a different bank. Call it Bank 2. As you can see, this process is continuous and will always generate more money into people’s hands and thus increase the supply of money in the economy. 

The Money Supply Numbers: M1, M2 and Beyond

The official division and quantification of the MS in a given economy are known as money supply aggregates. The order of the MS aggregates is based on how liquid the form of money in this category is.

The higher the liquidity, the easier it is for an asset to be transformed into cash and used instantly to purchase at any time.

Let’s look at the different money aggregates:

1. Monetary Base (MB)

MB is the total amount of money circulating in the public hands and the money placed in bank reserves. Outside of money owned by the public, the monetary base includes the money in reserves that belong to banks. These reserves are located in the central bank.

2. M0

M0 accounts for all the money in circulation. In addition to cash in public, this includes money held in bank reserves. We call this monetary aggregate the most liquid aggregate, as its form of money is easiest and quickest to use. The main examples are cash and coins.

3. M1

For M1, we combine all the cash circulated in the hands of the public while also including coins. The cash and coins could be held by customers or kept in banks accepting deposits.

Money in a savings or commercial bank account can still easily be transformed into cash. Therefore, we still consider M1 very liquid since it includes M0 in the calculation.

Anything easily and quickly transformed into cash for purchase is considered an M1 aggregate.

4. M2

In the M2 calculation, we also consider M1. In addition to M1, we add savings, time deposits, and mutual funds from the money market.

Note

M1 and M2 are the two most important aggregates when reporting and updating the public on the financial situation of the economy.

These money aggregates have correlated with the overall MS in a given economy. These money aggregates tell us how money is circulated and divided among the public and institutions.

This, as a result, gives us an insight into what an economy could expect in the short-term period, which gives the Fed time to react and decide what policies it should consider for controlling inflation and other important economic factors.

Monetary Policy and Money Supply

As mentioned above, the MS is greatly affected by the monetary policies that the Fed conducts.

After careful and thorough analysis, these policies are designed to change an economy’s supply of money; sometimes, they need to decrease the supply of money. At times, an increase in MS is needed. The biggest variable these policies attack is inflation.

The reason for this is to control economic stability. Too much money circulating is unhealthy for the economy, as it increases the prices of all goods, and most importantly, the value of a country’s currency becomes weak.

This is when the central bank must step in because situations like this can destroy the economy, especially if employees are not earning higher incomes.

Although this is a case where a high supply of money is bad, there are situations where the opposite must happen.

Making policies that allow an increase in the supply of money does good for the economy, as it can lead to more consumption and spending by the public.

You might be wondering how the Fed conducts these operations. Well, one of the ways they affect the money supply is by conducting open market operations.

This is when the central bank buys or sells market securities with banks. In exchange, this can increase or decrease the amount of money used for loans which eventually affects the money supply through a change in money circulation.

The second way is to change the reserve requirement ratio (rrr). This ratio determines how much a bank must keep a reserve amount saved in the bank.

As we discussed earlier, when a customer makes a deposit, the bank is forced to keep a portion of that amount as reserves if the customer needs to withdraw some of that amount for a purchase.

Increasing the reserve required ratio means the bank needs to reserve more money for its customer, but it also means less money will be available for loans to those in need. Therefore, this process can decrease the overall money circulation and the MS.

The Main Monetary Policies

Two main policies are used by higher authorities to implement changes in the economy:

1. Contractionary Monetary Policy

This method involves lowering an economy’s MS using the securities they own. The federal reserve sells the securities using the open market operations process.

This results in customers purchasing them using money they keep in the bank. This negatively affects the amount of money the bank can hold with them for loan purposes, resulting in less money supplied to the public.

When there is not enough money to loan, this decreases borrowing and, therefore, overall investment and consumption decrease.

Instead, people must hold their money without spending and circulating it.

This process is usually conducted when economists realize that the price level is increasing uncontrollably and they must lower the MS.

2. Expansionary Monetary Policy

At other times, the MS must be increased to save a country's economy. As the name “expansionary” suggests, the goal here is growth, especially when an economy is not performing well.

In contrast to a contractionary monetary policy, this policy buys instead of selling securities, also using open market operations. This results in more money held in banks for loan purposes, which means more money supplied to the public.

Due to the increase in MS, people will be more encouraged to borrow and spend money, resulting in more circulation. This policy leads to more investment and overall economic growth.

Researched and authored by Dani Abed | LinkedIn

Reviewed and edited by Parul GuptaLinkedIn

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