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Money Supply

Econ Focus
First Quarter 2019
Jargon Alert
Money supply

Timothy Cook

When the economist Milton Friedman said that "inflation is always and everywhere a monetary phenomenon," he was highlighting the relationship between inflation and the supply of money in the economy. To see this relationship in action, we can look at famous cases of hyperinflation, such as the Weimar Republic of pre-World War II Germany. To pay reparations from World War I, the German government began rapidly printing money, thereby increasing the amount of money in the economy. The large increase in the supply of money caused the value of a single bill to become less than it was the day before. Storeowners raised their prices in response and so consumers needed more currency to buy the same quantity of goods; this process continued until eventually people would bring wheelbarrows of cash to buy simple household items. Even today, there are occasional cases of hyperinflation — such as in Venezuela, where the supply of money has recently increased by double digits in percentage terms on a weekly basis.

But what, exactly, is the money supply? Economists have used four main measures, known as M0, M1, M2, and M3. The four measures are nested: M3 includes M1 and M2; M2 includes M0 and M1.

The main feature distinguishing the four measures is the liquidity of their components (how easily one can exchange the asset for cash). The smallest and most liquid measure, M0, is strictly currency in circulation plus commercial bank reserve balances at Federal Reserve Banks; M0 is often referred to as the "monetary base." M1 is defined as the sum of currency in circulation, demand deposits at commercial banks, and other liquid deposits; it is often referred to as "narrow money." M2 is everything included in M1 plus savings accounts, time deposits (under $100,000), and retail money market funds. M3 is everything in M2 plus larger time deposits and institutional money market funds. (Because the cost of estimating M3 was thought to outweigh its value, the Fed stopped reporting it in 2006.)

Our Related Research

"Large Excess Reserves and the Relationship between Money and Prices," Economic Brief No. 19-02, February 2019.

Additionally, as pointed out by the monetarist economist Anna Schwartz, there is a relationship between the components of these measures of money supply and how they are primarily used as a medium of exchange or a store of value. The components of the most liquid measures of the money supply, M0 and M1, all act as a medium of exchange in the economy, while the added components of M2 are used primarily as a store of value. Thus, the general idea is that there is a positive relationship between the medium of exchange property and liquidity.

The role of the money supply in the way that many economists think about inflation has evolved in the past decade as a result of changes in how the Fed conducts monetary policy. Before 2008, an increase in the monetary base was generally agreed to stimulate the economy in the short run and increase the price level in the long run. Today, monetary policy remains central in the determination of inflation, but the role of the monetary base is much reduced.

What changed is that the Fed received authority from Congress to pay interest on reserves (IOR) to banks for the reserves they hold at the Fed. The Fed responded to the 2007-2009 recession in part by engaging in massive purchases of Treasuries and mortgage-backed securities, adding greatly to the monetary base. By adjusting the interest rate on reserves appropriately, inducing banks to maintain high levels of reserves at the Fed, the Fed avoided the situation in which this infusion into the monetary base would lead to inflationary increases in bank deposits and lending and, therefore, in the money supply.

In short, in the post-2008 world, the Fed controls inflation by controlling the interest rate on excess reserves. Thus, an increase in the monetary base no longer necessarily leads to an increase in the money supply or, therefore, to an increase in the price level. Put differently, the familiar textbook relationship between central bank money creation and inflation has become less useful for understanding inflation.

M1 and IOR might not be the best cocktail party conversation starters, but knowing about the money supply and its evolving role is important for monetary policy.

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