What Is the Money Supply?

The U.S. money supply comprises currency—dollar bills and coins issued by the Federal Reserve Arrangement and the U.S. Treasury—and various kinds of deposits held by the public at commercial banks and other depository institutions such equally thrifts and credit unions. On June 30, 2004, the money supply, measured equally the sum of currency and checking account deposits, totaled $1,333 billion. Including some types of savings deposits, the money supply totaled $6,275 billion. An even broader measure totaled $9,275 billion.

These measures correspond to three definitions of money that the Federal Reserve uses: M1, a narrow measure of coin'southward office as a medium of exchange; M2, a broader measure that also reflects coin's role every bit a shop of value; and M3, a even so broader mensurate that covers items that many regard as close substitutes for money.

The definition of money has varied. For centuries, physical bolt, most commonly silver or gold, served as coin. Later on, when newspaper money and checkable deposits were introduced, they were convertible into commodity money. The abandonment of convertibility of money into a commodity since August 15, 1971, when President Richard M. Nixon discontinued converting U.Southward. dollars into gilded at $35 per ounce, has made the monies of the United States and other countries into fiat money—money that national monetary government have the power to upshot without legal constraints.

Why Is the Coin Supply Important?

Considering money is used in virtually all economic transactions, it has a powerful effect on economic activeness. An increase in the supply of money works both through lowering involvement rates, which spurs investment, and through putting more money in the hands of consumers, making them feel wealthier, and thus stimulating spending. Business firms respond to increased sales past ordering more than raw materials and increasing product. The spread of business activity increases the need for labor and raises the demand for capital appurtenances. In a buoyant economy, stock market prices rise and firms event equity and debt. If the coin supply continues to expand, prices begin to rise, especially if output growth reaches capacity limits. As the public begins to expect inflation, lenders insist on higher interest rates to offset an expected decline in purchasing power over the life of their loans.

Contrary effects occur when the supply of money falls or when its rate of growth declines. Economic activity declines and either disinflation (reduced inflation) or deflation (falling prices) results.

What Determines the Money Supply?

Federal Reserve policy is the most of import determinant of the money supply. The Federal Reserve affects the coin supply by affecting its well-nigh important component, banking concern deposits.

Here is how it works. The Federal Reserve requires depository institutions (commercial banks and other financial institutions) to hold as reserves a fraction of specified deposit liabilities. Depository institutions hold these reserves equally cash in their vaults or Automatic Teller Machines (ATMs) and as deposits at Federal Reserve banks. In plough, the Federal Reserve controls reserves by lending money to depository institutions and changing the Federal Reserve disbelieve rate on these loans and past open up-market operations. The Federal Reserve uses open-marketplace operations to either increase or decrease reserves. To increment reserves, the Federal Reserve buys U.Due south. Treasury securities by writing a cheque drawn on itself. The seller of the treasury security deposits the bank check in a bank, increasing the seller'southward deposit. The bank, in plow, deposits the Federal Reserve cheque at its district Federal Reserve bank, thus increasing its reserves. The opposite sequence occurs when the Federal Reserve sells treasury securities: the purchaser's deposits fall, and, in turn, the bank's reserves fall.

If the Federal Reserve increases reserves, a unmarried bank can make loans up to the amount of its excess reserves, creating an equal amount of deposits. The banking system, nevertheless, can create a multiple expansion of deposits. Every bit each bank lends and creates a eolith, information technology loses reserves to other banks, which utilize them to increase their loans and thus create new deposits, until all excess reserves are used upwards.

If the required reserve ratio is 10 per centum, then starting with new reserves of, say, $ane,000, the most a bank can lend is $900, since it must go along $100 as reserves against the deposit it simultaneously sets upwardly. When the borrower writes a check confronting this amount in his bank A, the payee deposits it in his banking concern B. Each new demand eolith that a bank receives creates an equal amount of new reserves. Banking company B will now accept boosted reserves of $900, of which it must go along $90 in reserves, so information technology can lend out only $810. The total of new loans the cyberbanking arrangement as a whole grants in this example volition be 10 times the initial amount of excess reserve, or $9,000: 900 + 810 + 729 + 656.one + 590.five, and so on.

In a arrangement with fractional reserve requirements, an increment in banking company reserves can support a multiple expansion of deposits, and a decrease can result in a multiple contraction of deposits. The value of the multiplier depends on the required reserve ratio on deposits. A high required-reserve ratio lowers the value of the multiplier. A low required-reserve ratio raises the value of the multiplier.

In 2004, banks with a total of $7 million in checkable deposits were exempt from reserve requirements. Those with more than $7 million simply less than $47.half-dozen million in checkable deposits were required to go along iii percent of such accounts as reserves, while those with checkable accounts amounting to $47.6 million or more were required to go on 10 per centum. No reserves were required to exist held against time deposits.

Even if at that place were no legal reserve requirements for banks, they would even so maintain required clearing balances every bit reserves with the Federal Reserve, whose ability to control the book of deposits would not be dumb. Banks would continue to keep reserves to enable them to clear debits arising from transactions with other banks, to obtain currency to meet depositors' demands, and to avert a deficit as a result of imbalances in clearings.

The currency component of the coin supply, using the M2 definition of money, is far smaller than the deposit component. Currency includes both Federal Reserve notes and coins. The Board of Governors places an lodge with the U.S. Bureau of Engraving and Printing for Federal Reserve notes for all the Reserve Banks and and then allocates the notes to each district Reserve Bank. Currently, the notes are no longer marked with the private district seal. The Federal Reserve Banks typically agree the notes in their vaults until sold at face up value to commercial banks, which pay private carriers to choice upwardly the cash from their district Reserve Bank.

The Reserve Banks debit the commercial banks' reserve accounts as payment for the notes their customers demand. When the need for notes falls, the Reserve Banks accept a render menses of the notes from the commercial banks and credit their reserves.

The U.South. mints design and manufacture U.S. coins for distribution to Federal Reserve Banks. The Lath of Governors places orders with the appropriate mints. The system buys coin at its face value by crediting the U.S. Treasury's account at the Reserve Banks. The Federal Reserve System holds its coins in 190 coin terminals, which armored carrier companies own and operate. Commercial banks buy coins at face value from the Reserve Banks, which receive payment by debiting the commercial banks' reserve accounts. The commercial banks pay the total costs of shipping the money.

In a fractional reserve banking system, drains of currency from banks reduce their reserves, and unless the Federal Reserve provides adequate boosted amounts of currency and reserves, a multiple contraction of deposits results, reducing the quantity of money. Currency and bank reserves added together equal the monetary base, sometimes known equally loftier-powered money. The Federal Reserve has the power to control the issue of both components. Past adjusting the levels of banks' reserve balances, over several quarters it can achieve a desired rate of growth of deposits and of the money supply. When the public and the banks change the ratio of their currency and reserves to deposits, the Federal Reserve can first the effect on the money supply past changing reserves and/or currency.

If the Federal Reserve determines the magnitude of the money supply, what makes the nominal value of money in existence equal to the amount people desire to hold? A change in interest rates is i way to make that correspondence happen. A fall in interest rates increases the amount of coin people wish to hold, while a rise in interest rates decreases that amount. A alter in prices is another style to brand the money supply equal the corporeality demanded. When people hold more nominal dollars than they want, they spend them faster, causing prices to rising. These ascension prices reduce the purchasing power of money until the amount people want equals the amount bachelor. Conversely, when people hold less money than they want, they spend more than slowly, causing prices to autumn. Equally a result, the existent value of money in existence only equals the amount people are willing to hold.

Changing Federal Reserve Techniques

The Federal Reserve's techniques for achieving its desired level of reserves—both borrowed reserves that banks obtain at the discount window and nonborrowed reserves that information technology provides by open-market purchases—have inverse significantly over time. At first, the Federal Reserve controlled the volume of reserves and of borrowing by fellow member banks mainly by changing the discount charge per unit. It did so on the theory that borrowed reserves made member banks reluctant to extend loans considering their want to repay their ain indebtedness to the Federal Reserve as soon as possible was supposed to inhibit their willingness to suit borrowers. In the 1920s, when the Federal Reserve discovered that open-marketplace operations also created reserves, changing nonborrowed reserves offered a more effective way to first undesired changes in borrowing by member banks. In the 1950s, the Federal Reserve sought to command what are chosen gratis reserves, or excess reserves minus member bank borrowing.

The Fed has interpreted a rise in involvement rates as tighter monetary policy and a autumn every bit easier monetary policy. But interest rates are an imperfect indicator of monetary policy. If easy budgetary policy is expected to crusade inflation, lenders need a higher interest rate to recoup for this aggrandizement, and borrowers are willing to pay a higher charge per unit because inflation reduces the value of the dollars they repay. Thus, an increase in expected aggrandizement increases interest rates. Between 1977 and 1979, for example, U.S. monetary policy was easy and interest rates rose. Similarly, if tight monetary policy is expected to reduce aggrandizement, interest rates could fall.

From 1979 to 1982, when Paul Volcker was chairman of the Federal Reserve, the Fed tried to control nonborrowed reserves to achieve its budgetary target. The process produced large swings in both coin growth and involvement rates. Forcing nonborrowed reserves to decline when higher up target led borrowed reserves to rise because the Federal Reserve allowed banks access to the disbelieve window when they sought this alternative source of reserves. Since and then, the Federal Reserve has specified a narrow range for the federal funds rate, the involvement rate on overnight loans from 1 bank to some other, as the musical instrument to achieve its objectives. Although the Fed does not directly transact in the Fed funds market, when the Federal Reserve specifies a college Fed funds rate, information technology makes this higher rate stick by reducing the reserves it provides the entire fiscal arrangement. When information technology specifies a lower Fed funds rate, it makes this stick by providing increased reserves. The Fed funds market rate deviates minimally from the target charge per unit. If the deviation is greater, that is a signal to the Fed that the reserves information technology has provided are not consequent with the funds rate it has announced. It will increase or reduce the reserves depending on the departure.

The big change in Federal Reserve objectives under Alan Greenspan's chairmanship was the acknowledgment that its key responsibility is to control inflation. The Federal Reserve adopted an implicit target for projected futurity inflation. Its success in meeting its target has gained it brownie. The target has become the public's expected inflation rate.

History of the U.S. Money Supply

From the founding of the Federal Reserve in 1913 until the stop of World War II, the money supply tended to grow at a higher charge per unit than the growth of nominal GNP. This increment in the ratio of money supply to GNP shows an increase in the corporeality of money equally a fraction of their income that people wanted to hold. From 1946 to 1980, nominal GNP tended to grow at a college rate than the growth of the money supply, an indication that the public reduced its money balances relative to income. Until 1986, coin balances grew relative to income; since then they have declined relative to income. Economists explain these movements by changes in price expectations, likewise every bit by changes in interest rates that make money holding more or less expensive. If prices are expected to fall, the inducement to concur money balances rises since money volition buy more if the expectations are realized; similarly, if interest rates autumn, the price of belongings money balances rather than spending or investing them declines. If prices are expected to rise or interest rates ascension, holding money rather than spending or investing information technology becomes more costly.

Since 1914 a sustained pass up of the money supply has occurred during just three business cycle contractions, each of which was astringent as judged by the decline in output and rise in unemployment: 1920–1921, 1929–1933, and 1937–1938. The severity of the economic pass up in each of these cyclical downturns, it is widely accepted, was a consequence of the reduction in the quantity of coin, particularly and so for the downturn that began in 1929, when the quantity of money cruel by an unprecedented one-third. In that location have been no sustained declines in the quantity of money in the past vi decades.

The United states of america has experienced three major cost inflations since 1914, and each has been preceded and accompanied by a corresponding increase in the rate of growth of the money supply: 1914–1920, 1939–1948, and 1967–1980. An dispatch of coin growth in excess of real output growth has invariably produced inflation—in these episodes and in many before examples in the United States and elsewhere in the earth.

Until the Federal Reserve adopted an implicit inflation target in the 1990s, the coin supply tended to rise more speedily during business cycle expansions than during business organization cycle contractions. The rate of ascension tended to fall before the summit in business and to increase before the trough. Prices rose during expansions and roughshod during contractions. This pattern is currently not observed. Growth rates of money aggregates tend to be moderate and stable, although the Federal Reserve, like almost central banks, now ignores coin aggregates in its framework and practice. A possibly unintended issue of its success in controlling aggrandizement is that money aggregates accept no predictive power with respect to prices.

The lesson that the history of coin supply teaches is that to ignore the magnitude of money supply changes is to court budgetary disorder. Fourth dimension will tell whether the electric current budgetary nirvana is enduring and a challenge to that lesson.

About the Author

Anna J. Schwartz is an economist at the National Bureau of Economic Research in New York. She is a distinguished fellow of the American Economic Clan.

Further Reading

Eatwell, John, Murray Milgate, and Peter Newman, eds. Money: The New Palgrave. New York: Norton, 1989.

Friedman, Milton. Monetary Mischief: Episodes in Monetary History. New York: Harcourt Brace Jovanovich, 1992.

Friedman, Milton, and Anna J. Schwartz. A Monetary History of the U.s., 1867–1960. Princeton: Princeton University Press, 1963.

McCallum, Bennett T. Monetary Economics. New York: Macmillan, 1989.

Meltzer, Allan H. A History of the Federal Reserve. Vol. ane: 1913–1951. Chicago: University of Chicago Press, 2003.

Rasche, Robert H., and James M. Johannes. Controlling the Growth of Monetary Aggregates. Rochester Studies in Economies and Policy Issues. Boston: Kluwer, 1987.

Schwartz, Anna J. Money in Historical Perspective. Chicago: University of Chicago Printing, 1987.