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Money Supply by Mike Finnegan

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Money Supply by Mike Finnegan JARGONALERT Money Supply By MikE FinnEgan hen the economist Milton Friedman said components of these measures of money supply and how that “inflation is always and everywhere a they are primarily used as a medium of exchange or a store Wmonetary phenomenon,” he was highlight- of value. The components of the most liquid measures ing the relationship between inflation and the supply of of the money supply, M0 and M1, all act as a medium of money in the economy. To see this relationship in action, exchange in the economy, while the components of M2 we can look at famous cases of hyperinflation, such as the are used primarily as a store of value; M3, in turn, can be Weimar Republic of pre-World War II Germany. To pay thought of as a close substitute for money. Thus, the gen- reparations from World War I, the German government eral idea is that there is a positive relationship between the began rapidly printing money, thereby increasing the medium of exchange property and liquidity. amount of money in the economy. The large increase in The role of the money supply in the way that many the supply of money caused the value economists think about inflation of a single bill to become less than has evolved in the past decade as it was the day before. Storeowners a result of changes in how the Fed raised their prices in response and so conducts monetary policy. Before consumers needed more currency to 2008, an increase in the monetary buy the same quantity of goods; this base was generally agreed to stim- process continued until eventually ulate the economy in the short run people would bring wheelbarrows and increase the price level in the of cash to buy simple household long run. Today, monetary policy items. Even today, there are occa- remains central in the determination sional cases of hyperinflation ­­— such of inflation, but the role of the mon- as in Venezuela, where the supply etary base is much reduced. of money has recently increased by What changed is that the Fed double digits in percentage terms on received authority from Congress a weekly basis. to pay interest on reserves (IOR) But what, exactly, is the money to banks for the reserves they hold supply? Economists have used four at the Fed. The Fed responded to main measures, known as M0, M1, the 2007-2009 recession in part by M2, and M3. The four measures are engaging in massive purchases of nested: M3 includes M1 and M2; M2 Treasuries and mortgage-backed includes M0 and M1. securities, adding greatly to the mon- The main feature distinguishing etary base. By adjusting the interest the four measures is the liquidity of their components rate on reserves appropriately, inducing banks to main- (how easily one can exchange the asset for cash). The tain high levels of reserves at the Fed, the Fed avoided smallest and most liquid measure, M0, is strictly currency the situation in which this infusion into the monetary in circulation and money being kept by banks in reserves; base would lead to inflationary increases in bank deposits hence, M0 is often referred to as the “monetary base.” and lending and, therefore, in the money supply. M1 is defined as all of M0 plus the remaining demand In short, in the post-2008 world, the Fed controls infla- deposits not in reserves as well as traveler’s checks; it is tion by controlling the interest rate on excess reserves. often referred to as “narrow money.” M2 is everything Thus, an increase in the monetary base no longer necessar- included in M1 plus savings accounts, time deposits (under ily leads to an increase in the money supply or, therefore, to $100,000), and retail money market funds. M3 is every- an increase in the price level. Put differently, the familiar thing in M2 plus larger time deposits and institutional textbook relationship between central bank money cre- money market funds. (Because the cost of estimating M3 ation and inflation has become less useful for understanding was thought to outweigh its value, the Fed stopped report- inflation. mothy Cook ing it in 2006.) M1 and IOR might not be the best cocktail party con- tI on: Additionally, as pointed out by the monetarist econo- versation starters, but knowing about the money supply and I mist Anna Schwartz, there is a relationship between the its evolving role is important for monetary policy. EF Illustrat 6 E con F ocus | F irst Q uartEr | 2019.
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