Modern Measures of Money

The Money Supply and Measures of Money

The Money Supply
                Money Supply – is defined as the amount of money circulating in the
economy.
                While a number of factors determine how fast or how slowly prices move
up, a key driver of inflation is the money supply. When there is too much money
going around chasing too few goods, the inevitable result is for prices to move up.
                Whoever manages the money supply (ex. the US Federal Reserve, the BSP,
etc.) must make sure that the money supply keeps pace with the actual growth in
production of goods and services in the economy.
Money Supply (An Example)
Demand deposits*                                                            $            159,800
Currency and coin                                         
Federal reserve notes                                                       44,450
Treasurycurrency                                                              620
Coins                                                                          5,690                                                               
210,760
Less currency and coin held by banks                                             7,060
Total public money supply                                              $        203,700
*Demand deposits other than interbank and US government, less cash items in
process of collection

Factors that Change the Money Supply

Changes in the Money Supply, 1980-2006

Effects of Changes in Money Supply
 

Two Approaches in Measuring Money

The Transaction Approach
•       Emphasizes money’s function as a medium of exchange.
Note: GS and savings deposits are excluded because they must first be converted
before spending.
•       A CB controls the supply of money used to make transactions.
•       Money shows a reliable and predictable relationship to national economic goals.
The Liquidity Approach
Stresses that very liquid assets should be easily converted into money without loss of
nominal value.
Empirical Measures of Money
•       The different functions of money are associated with different empirical
measures of the money supply.
•       The supply of money is broken down into types of money based on how much of
an effect monetary policy can have on each.
•       Narrow measures include those more directly affected by monetary policy,
whereas broader measures are less closely related to monetary-policy actions.
•       The different types of money are typically classified as Ms. The number of Ms
usually range from M0 (narrowest) to M3 (broadest) but which Ms are actually used
depends on the system.
M1, M2 and the Monetary Base
•       M0 – includes bank reserves; M0 is referred to as the monetary base, or narrow
money.
•       MB (Monetary Base or Total Currency) – currency in circulation plus reserves. 
Note:  This is the base from which other forms of money (like checking deposits) are
created and is traditionally the most liquid measure of the money supply.
•       M1 – currency in circulation plus demand deposits (in a bank) and traveler’s
checks (issued by nonbanks). (Note: bank reserves are not included in M1.)
•       M2 –  represents money and "close substitutes" for money.
               
               

The M2 formula:
M2 = M1+overnight REPOs+overnight Eurodollars+Money Market Mutual
Funds+Savings Deposits+ small-denominated Time Deposits,
•       M2 is a broader classification of money than M1. Economists use M2 in
quantifying the amount of money in circulation and explaining different economic
monetary conditions. M2 is a key economic indicator when forecasting inflation.
•       M3 –  Since 2006, M3 is no longer published or revealed to the public by the US
central bank. However, there are still estimates produced by various private
institutions.
•       MZM –  Money with zero maturity. It measures the supply of financial assets
redeemable at par on demand.
                Note:  The ratio of a pair of these measures, most often M2/M0, is called an
actual or empirical money multiplier.
•       The CB has greater control over the MB than it does over M1
–         Checkable deposits are influenced by a number of factors that the CB does not
have direct control over.
•       We link MB and M1 together through the money multiplier
–         M1 = m*MB
–         For every $1 increase in the MB, the money supply (M1) increases by m*$1
–         m is almost always greater than 1.
The Money Multiplier
The Money Multiplier (also called the credit multiplier or the deposit multiplier) –  is
a measure of the extent to which the creation of money in the banking system causes
the growth in the money supply to exceed growth in the monetary base.
                The money multiplier is usually restricted to deposits in banks, this implies
that we are talking about M1 (most commonly) or M2.
                Multipliers can also be calculated for broad money measures such as M3
and M4.
Factors that Determine the Money Multiplier
•       Changes in the required reserve ratio (r)
–         The money multiplier and the money supply are negatively related to r
•       Changes in the currency ratio (cr)
–         The money multiplier and the money supply are negatively related to cr
•       Changes in the excess reserves ratio (e)
–         The money multiplier and the money supply are negatively related to the
excess reserves ratio e
Deriving the Money Multiplier
Derivation of m1
C = currency in circulation
cr = currency ratio
D= demand deposit (checking account)
rr = required reserve rate
e = excess reserves = r–rr
m1 = M1 Money multiplier = M1/MB
M1 = Money supply = C+D
MB = Monetary base = C+R
R = Total actual reserves
Example 1
•       Suppose the desired currency ratio is 40%, the reserve requirement is 10% and
the excess reserve ratio is 0.5%
•       The money multiplier is
–         A one dollar increase in the monetary base will lead to a $2.77 ($1 x 2.77)
increase in the money supply
•       Accounting for currency and excess reserves is clearly important.
 
Example 2
•       Let cr=25% , e = 0.10%, and rr = 10%.  Compute the money multiplier

•       The CB decides to increase rr to 20%.  What happens to the money multiplier

(and the money supply as a result)

 
–         A smaller multiplier means that banks create less money through lending and
therefore the money supply will fall.
Example 3
•       What happens to the money multiplier when the desired currency ratio rises?
•       Let cr = 20%, rr = 25%, and e = 5%

•       Now suppose cr rises to 30%, while all other variables remain constant

 
•       Increasing the fraction of deposits held as currency causes the money supply to
fall
–         Money is being taken out of the banking system where it could have been used
to make loans.
Deriving the Money Multiplier
Derivation of m2
The M2 money supply is defined as M1 money supply
plus Overnight Repos
plus Overnight eurodollars
plus money market mutual funds
plus savings deposits
plus small-denominated time deposits
•       To keep matters simple all of the above items (except for large-denominated
time deposits) will be grouped together as MMF.  Thus, M2 = M1 + T + MMF.
               
                Note: M2 is used by economists to forecast inflation.
How CB manages money supply?
                To understand how a CB manages money supply—we need to understand
how the banking system “creates” money.
                Banks are in the business of taking our deposits and making them grow by
much more than what they pay us (in interest).
                They do this by lending our money to various borrowers: Businesses who
need money to invest in an enterprise, consumers wishing to buy a house or car, or
even government (when banks invests in interest-earning government securities).
                Ex. A reserve requirement of 20% means that for every $1,000 deposit
banks take in, they should hold $200 ($1,000 x 20%) in reserve and lend out $800
[i.e., $1,000 x (1– 0.20)].
                When they loan out $800, that money eventually ends up being deposited in
banks again, leading to a new round of $640 [$800 x (1 – 0.20)] in loans, which in
turn end up being deposited somewhere, thereby leading to new loans of $512 [$640 x
(1 – 0.20)], so on and so forth.