I bet you already saw this, but for those here who might not have seen it:
Why the money supply made the news
02.12.2005
The Fed has announced that it will no longer publish the M3 measure of the money supply. This may sound dull, but it has sparked a terrible row in financial circles.
What is the ‘money supply’?
It’s the name economists give to all the money circulating in a given nation’s economy. The US money supply comprises currency (the dollar bills and coins issued by the Treasury and the Federal Reserve system of federal and state banks) and various kinds of deposits held by the public at banks and similar institutions. However, there are several different definitions of the money supply, known as M0, M1, M2 and M3. The broadest measure is M3 (see below). This sounds boring, but it isn’t: as money is used in virtually all economic transactions, how much of it there is about and the ease with which borrowers can get hold of it is crucial to the economy.
How does the money supply affect the economy?
When the supply of money grows, consumers feel wealthier and are encouraged to spend more on goods and services. Businesses respond to rising sales by buying more raw materials and increasing production – in turn requiring more labour and more capital. However, if the money supply expands too much, prices will start to rise, especially if the growth in output is hitting the limits of capacity. As inflation kicks in, lenders demand higher interest rates on money they lend out to compensate them for the fact that, when they get their money back, it won’t be worth as much as it was when they first lent it out. Conversely, when the supply of money falls, or when its rate of growth falls, the economy can be affected in opposite ways. Economic activity declines and the result is lower inflation (disinflation).
How is the money supply controlled in the US?
The idea is that the Fed encourages sufficient money growth to sustain economic prosperity and foster a stable climate for economic growth while keeping inflation (or deflation) under control. The Fed has three levers it can use to do this. First, it tells deposit-taking institutions what share of funds (the ‘reserve requirement’) they must hold in reserve against deposit liabilities. Thus the Fed can shrink, or tighten, the money supply by requiring banks to hold more in reserve, which pulls money out of the system – or it can loosen or ease the money supply by lowering reserve requirements. Second, the Fed sets the federal funds rate – the rate banks charge each other for overnight borrowing – and the discount rate, which the Fed charges other banks. Banks pass on these changes by adjusting their own rates: thus higher Fed rates encourage less borrowing and a tighter money supply and vice versa. Finally, the Fed can buy and sell US Treasury securities. If the Fed wants more credit to be available, it buys securities and pays by crediting the reserves of banks involved in the transaction. Banks thus have more money to lend out and interest rates should fall. When the Fed sells securities, banks end up with less money to lend, and rates should rise.
Why is the money supply in the news?
Last month, the US Federal Reserve announced it will no longer be publishing M3 – sparking controversy in financial circles and putting the normally arcane subject of the money supply at the centre of a conspiracy theory. According to the cynics, the US government is on a mission to reflate the US economy by generating excess liquidity while pretending not to. In other words, even as the Fed appears to tighten monetary policy by slowly raising interest rates in cautious quarter-point instalments (from 1% in June 2004 to 4% today), its real goal is to loosen controls on the monetary supply in order to inflate away the enormous US debt without getting rumbled – what economists refer to as the ‘monetisation’ of the debt problem.
Is there anything in this?
It might seem wacky, but there is some circumstantial evidence. The Fed says the elimination of M3 reporting is a cost-cutting move, arguing that it doesn’t contribute to monetary policy. Critics point out that the idea of this administration worrying about cost-cutting is laughable, and that the Fed will still collate the figures, just not publish them. They also point out that despite a year of apparent monetary tightening, M3 stands at more than $10trn and is growing at an annual rate of 7.5%. On the other hand, M2 is growing at a more modest 4%. At the same time, the conspiracy theorists’ case seems to have been given a boost by the appointment of Ben Bernanke. Bernanke, who takes over from Alan Greenspan in January, famously remarked two years ago that if the US economy was running into trouble, the government would print money to get the economy moving. But if under Bernanke this happens, where might the excess liquidity in the money supply show up? In the discontinued M3 figures, says The New York Post.
How is the money supply measured?
M1 is a narrow measure of money’s most basic function as a handy medium of exchange. It comprises all the paper cash and coins in circulation (M0), plus the total amount in current accounts and instant access savings accounts. M2 is a broader measure that reflects money’s function as a store of value. It is made up of M1 plus various other types of savings account, money market accounts and certificate of deposit accounts worth less than $100,000. The broadest measure, which covers everything covered by M2, plus other items that many regard as close substitutes for money – certificates of deposit worth more than $100,000, deposits of eurodollars and repurchase agreements – is known as M3. |
