Saturday, March 8, 2008

Money supply and control

Measuring money

What is money supply?
It's the stock of money and the supply of new money. The currency in circulation - coins and notes that people spend - makes up only a very small part of the money supply. The rest consists of bank deposits.

How do we measure it?
It depends on whether you include time deposits - bank deposits that can only be withdrawn after a certain period of time. The smallest measure is called narrow money. This only includes currency and sight deposits - bank deposits that customers can withdraw whenever they like. The other measures are of broad money. This includes savings, deposits and time deposits, as well as money market funds, certificates of deposit, commercial paper, repurchase agreements, etc.

What about spending?
To measure money you also have to know how often it is spent in a given period. This is money's velocity of circulation - how quickly it moves from one institution or bank account to another. In other words, the quantity of money spent is the money supply times its velocity of circulation.

Changing the money supply

The monetary authorities - sometimes the government, but usually the central bank - use monetary policy to try to control the amount of money in circulation, and it's growth. This is in order to prevent inflation - the continuous increase in prices, which reduces the amount of things that people can buy.
What can they do to control that?

  • They can change the discount rate at which the central bank lends short-term funds to commercial banks. The lower interest rates are, the more money people and businesses borrow, which increases the money supply.
  • They can change commercial banks' reserve-asset ratio. This sets the percentage of deposits a bank has to keep in the reserves (for depositors who wish to withdraw their money), which is generally around 10%. The more a bank has to keep, the less it can lend, thus decreasing the money supply.
  • The central bank can also buy or sell treasury bills in open-market operations with commercial banks. If the banks buy these bonds, they have less money (and so can lend less), and if the central bank buys them back, the commercial banks have more money to lend.

Monetarist economists are those who argue that if you control the money supply, you can control inflation. They believe the average levels of prices and wages depend on the quantity of money in circulation. and its velocity of circulation. They think that inflation is caused by too much monetary growth: too much new money being added to the money stock. Other economists disagree. They say the money supply can grow because of increased economic activity: more goods being sold and more services being performed.

Well, now that you know the basics of money supply and its control, can you tell me, which kind of economist, are YOU?

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