Meaning of money supply
Money supply is the total amount of all forms of money circulating in an economy. It comprises the forms of money that serve as a medium of exchange and store of value, e.g., currency, demand deposits, time deposits, etc. The components of money supply may vary by country or region. For example, the major measures of money in the UK are narrow money supply and broad money supply. The US has three types of money supply, namely M1, M2 and M3.
Narrow and broad money (Bank of England)
Narrow money
This is the most liquid monetary aggregate which enables money to carry out its main function as a medium of exchange. It comprises cash (notes and coins) and overnight deposits. The Bank of England (BoE) measures M1 which has become the narrowest measure of money supply following the stoppage of the publication of M0 in 2006. M0 only considered currency in circulation outside the central bank but excluded bank deposits. Cash held outside the central bank is made up of cash held by individuals, firms, banks and the public sector.
M1 is better than M0 because bank deposits are an important source of our spending and they account for the bulk of money in circulation in developed economies. Narrow money is also known as monetary base.
Broad money
Broad money, also known as M4, is the main measure of money supply in the UK. It is more reliable as different types of bank deposits are included. It is the addition of narrow money and other forms of money that are less liquid.
Broad money is money used as a medium of exchange and store of value (savings accounts in banks and building societies). It is made up of notes and coins in circulation plus demand and time deposits.
M3H is the broadest monetary aggregate in the UK. It is the addition of M4 and foreign currency deposits with UK Monetary Financial Institutions (MFIs) by the private sector and UK public corporations.. MFIs are deposit-taking institutions, e.g., banks and building societies.
Money supply in the eurozone
There are three monetary aggregates published by the European Central Bank for the euro area, namely M1, M2 and M3. The narrowest money supply measure is M1 which comprises cash in circulation with the public and overnight deposits. M2 is the sum total of M1, deposits with an agreed maturity of up to two years and deposits redeemable at notice of up to three months.
M3 is the eurozone’s broad money and it consists of M2, repurchase agreements, money market funds and paper, and debt securities with a maturity of up to two years. The eurozone broad money M3 is broader than the UK’s M4 since the eurozone’s monetary aggregate includes other assets that are fairly liquid e.g., short-term money market funds/ securities.
Money supply by the Federal Reserve (USA)
The monetary measure M1, is the narrow money in the US. It comprises currency outside banks, demand deposits at commercial banks and other liquid deposits (other checkable deposits and savings accounts). Currency outside banks represents notes and coins outside the U.S. Treasury and Federal Reserve Banks.
M2 is the addition of M1, small-denomination time deposits and balances in retail money market funds. Small-denomination time deposits are time deposits in amounts of less than $100,000.
The broadest money in the US is M3 which is the total of M2, large-denomination time deposits, repurchase agreements, Eurodollar deposits, institution-only money market funds. The publication of M3 was brought to an end by the Federal Reserve in 2006.
The monetary base equals currency in circulation plus reserve balances. Reserve balances comprise Federal Reserve Banks’ excess balance and balances held by depository institutions in master accounts and excess balance accounts at Federal Reserve Banks.
Endogenous and exogenous money supply
Endogenous money supply depends on economic variables. This money supply is determined by the interest rate, i.e., it has a direct relationship with the interest rate. This results in an upward-sloping money supply curve. A rise in demand for money in an economy causes an increase in interest rate as money becomes scarce. Banks respond to an increase in interest rate by increasing their supply of money.
Figure 1: Endogenous money supply curve
Exogenous money supply is not linked to any economic variable. It is independent of interest rate and is fixed by the government or the central bank of the country. The amount of money supplied is at the discretion of the authority. A rise in demand for money does not affect the money supply. This produces a vertical or perfectly inelastic money supply curve.
Figure 2: Exogenous money supply curve
Factors that increase money supply
Reduced demand for money by nonbank private sector
Deregulation of the financial systems of many countries has encouraged improved financial technology and innovations. Consequently, new products are being developed to mop up excess cash from circulation. Money is now being held in e-wallets, digital bank accounts, etc. The money mobilised from the private sector (households and non-bank firms) by financial institutions can be given as loans to deficit units in the economy, thereby expanding the money supply.
Sale of government securities to banks
The money supply increases when banks buy government bonds or bills. The balances of these banks with the central bank are used to pay for the securities purchased. This will only reduce their balances with the central bank, not the ones with them. When the government spends the money realised from the sale, the recipients usually deposit the money in their accounts with banks; this would increase the money banks have to give out as credit. More credit will increase the amount of money in circulation.
However, money supply will not increase if a non-bank unit (individuals and firms) buys government securities. They will pay from their bank deposits, thereby reducing their bank balances. When the government spends the money, it will be redeposited in the banking system, and the total balance in the banks will be restored.
Low liquidity ratio for banks
Banks are required to keep a particular percentage of their total assets in liquid assets by regulators so that they can meet their short-term obligations, e.g., cash balance with the central bank. This is known as the liquidity ratio. Liquid assets can be easily and immediately converted to cash with minimal loss in value. Cash is the most liquid asset. Real estate is an example of an illiquid asset.
A low liquid ratio means that banks have to set aside a small proportion of their assets in liquid form while having a lot of money to give out as loans to customers. This is capable of increasing the amount of money in circulation.
Government borrowing from the central bank and commercial banks
Government borrows to finance a budget deficit. The money in circulation will increase when it spends the money borrowed from the central bank or commercial banks. Those who are paid by the government deposit their cheques in banks, thereby increasing the ability of banks to create more credit and increase the money supply.
Net inflow of money into the country
If the money coming from abroad through exports exceeds the money going out through imports, the money supply rises. In addition, if the government expands its foreign reserves by buying foreign currencies with domestic currency, the money supply will rise if the recipients of the domestic currency deposits the money in domestic banks or buy the country’s exports.