What is Money Supply?
Money supply refers to the cash and cash equivalents in a country at a given point in time. It is an important measurement for monetary policy decision-making because money supply is a key variable that drives macroeconomic performance.
- Money supply refers to the cash and cash equivalents in a country at a given point in time. It is categorized using the monetary aggregates system.
- It is a useful indicator of future economic performance because it is correlated with macroeconomic variables, such as inflation and interest rates.
- Money supply is one of the key tools in implementing monetary policy.
Understanding Money Supply
Monetary supply aggregates are the formal breakdown and measurement of money supply in the economy based on liquidity. M0 is the most liquid category, as it represents all the physical coinage and paper money in circulation.
Per the diagram below, as the circles broaden, each grouping encompasses increasingly illiquid assets, with M3 encompassing large deposits over $100,000, money market funds, and Eurodollar deposits.
Money Supply and the Business Cycle
Money supply data is published monthly and is one of the many important macroeconomic variables that are tracked by economists and investors alike. The variables can be used to determine the timing of the business cycle and future expectations. They are often intertwined and therefore must be understood together to draw conclusions.
Different assets and attributes outperform at different stages in the business cycle. By understanding where we are in the current business cycle, investors can strategically shift their portfolios to maximize their returns.
Money Supply and Monetary Policy
Monetary policy is a tool implemented by the central bank to maintain economic stability and growth. One of the biggest challenges monetary policy seeks to tackle is inflation. When spending (demand) is abnormally high and supply remains constant, it artificially pushes up the equilibrium price.
Too much inflation can spell disaster, because when the prices of goods increase but wages do not, it erodes the purchasing power of consumers and can quickly lead to decreased overall spending and an economic downturn. On the other hand, not enough inflation will result in a stagnant economy, or even worse, deflation will create a cycle of high unemployment and bankruptcies.
Monetary policy seeks to control inflation through the manipulation of money supply and interest rate targets, of which we will explore the former. When money supply is high, it boosts consumer spending and investments, which in turn spurs the economy. Vice versa, when the money supply is low, consumer spending and investments fall and, in the long term, can result in a declining economy.
The central bank uses two methods to influence the money supply:
- Buying or selling money market securities (M2) from the open market
- Easing or tightening reserve requirements
Reserve requirements are the required funds that banks must keep on hand at all times to meet abnormally high client withdrawal needs. By influencing reserve requirements, the central bank directly influences money in circulation (M0).
Types of Monetary Policy
The two types of monetary policy are:
1. Expansionary monetary policy
In times of economic slowdown, the government can expand monetary policy to encourage economic growth. It does so by buying securities from the open market and easing reserve requirements to increase the money supply, and on the other hand, reducing the interest rate target.
2. Contractionary monetary policy
When the economy overheats, high inflation rates in the long term can spell trouble because of reduced purchasing power. To lower inflation, the government can decrease the money supply and increase interest rates by selling securities on the open market, tightening reserve requirements, and increasing the interest rate target.
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