US Money Supply

Basic US Money Supply Definition

Before jumping into the deep end, you must get a firm grasp on the basic definition of the US Money Supply. The US Money Supply essentially refers to the total amount of monetary assets available in the United States at a specific time.

But what constitutes the US Money Supply isn't solely banknotes and coins. It is calculated and represented in different manners:

• M0: This is the most liquid form of money and refers to all physical money (like coins and currency notes).
• M1: This includes M0 plus demand deposits (like checkable deposits), traveller's checks, and other deposit accounts.
• M2: Includes M1 plus savings deposits, small-denomination time deposits (certificates of deposit of under $100,000), and money market accounts for individuals.

Each category represents a different level of liquidity or "spendability," with M0 being the most liquid.

Historical Context of US Money Supply

To fully comprehend the significance of the US Money Supply, let's take a look back at its historical context.

Most notably, the United States experienced a major money supply and banking reform in the 20th century, leading to the establishment of the Federal Reserve System in 1913. This was brought about by several banking panics and the need for a more centralised and standardised fiscal system.

Over the years, the federal government has adopted various measures to control the money supply, such as open market operations, changing the reserve requirements for banks, and altering the discount rate.

This serves as a testament to the dynamic nature of the money supply and how it keeps evolving with changing economic and banking conditions.

Components of the US Money Supply

To comprehend the US Money Supply in its entirety, it is integral to understand the components that makeup this notion. Principally, the US Money Supply is divided into two key components: M1 and M2.

What the US Money Supply Is Composed Of: M1 and M2 Explained

M1 and M2 are the two classifications of money used by economists to describe the money supply. They differ in their levels of liquidity, and understanding them can help elucidate the role of money in the economy.

Likewise, money market funds, traveller's cheques, and other highly liquid assets are counted in M1. Although these assets aren't "cash" in the traditional sense, they are quickly and easily converted into cash, and hence are included.

These assets aren't as easily accessible as those in M1, but they are still fairly liquid, meaning they can be converted into cash reasonably quickly.

Understanding US Money Supply M1

The M1 category is often described as "narrow money" because it includes forms of money that are highly liquid and typically used for immediate payments. This component of the money supply is heavily related to the transactions function of money, one of the four main functions of money in economics (the other three being unit of account, standard of deferred payment, and store of value).

M1 is the most immediate form of money. With the rise of electronic banking and payment technologies, the lines between physical money and demand deposits have blurred. Nowadays, many transactions can be completed without physical currency ever changing hands. Therefore, both physical currency and demand deposits are included in M1, as both are used directly to make payments.

Distinguishing Features of US M2 Money Supply

M2, or "broad money", includes all components of M1, and additionally includes assets that are slightly less liquid. The additional components in M2 are referred to as near money or quasi money. These are assets that can be converted into cash, but not as immediately as the components of M1.

Distinguishing M2 from M1 highlights the different roles money can play – as both a medium of exchange (M1), and as a way to store value for future use (M2). While the assets included in M1 serve as direct methods to facilitate exchanges, M2 shows the larger ecosystem of monetary assets available in an economy.

Knowledge of these two money supply components M1 and M2 helps understand the readiness of funds for immediate expenditure (narrow money) and saving (broad money), respectively. These measures help economists and policymakers track economic trends, construct monetary policies, and understand and predict how changes to money supply can impact economic output and inflation.

Practicality of the US Money Supply

In a practical sense, the measurement and monitoring of the US Money Supply helps to inform economic policy, can impact interest rates and plays a role in forecasting price levels, inflation, and business cycles. The greater the money supply growth rate, the lower the interest rate and vice versa. The reasoning here is that when money supply piles up faster than products and services, there is more demand than supply, which causes prices (and thus inflation) to rise. Conversely, a contraction in the money supply can lead to deflation.

Real-life US Money Supply Example

Let's consider a practical example where US Money Supply can show its impact. For instance, take into consideration the recent COVID-19 pandemic. It has had significant implications on the economy and has affected the overall money supply.

In response to the COVID-19 economic crisis, the Federal Reserve stepped in and implemented a series of actions designed to support the economy. Among these actions was an aggressive policy of quantitative easing, in which the central bank purchases large quantities of financial assets, essentially injecting money directly into the economy.

Inflation usually follows such a rapid increase in the money supply. However, at the same time, the economic crisis led to a sharp fall in velocity, which is the rate at which money moves from one transaction to another. This decline in velocity acted as a brake on inflation, thus demonstrating how several factors can interplay to affect the overall economy.

Interpreting Changes in Total US Money Supply

The values of the US Money Supply (both M1 and M2) are reported by the Federal Reserve, and changes in these numbers are watched closely by economists and policy-makers as indicators of economic trends.

When the money supply increases significantly, it could be seen as a positive sign for economic activity – businesses are investing, consumers have more spending power, leading to increased demand for goods and services. On the other hand, if money supply growth is too high and faster than the rate of economic growth, it could lead to inflationary pressures.

On the other hand, a reduction in money supply (known as contraction) might be seen as a sign that the economy is slowing down. If money supply contracts too quickly, it can lead to deflation, which could potentially trigger recessionary pressures as happened during the Great Depression.

The study and interpretation of changes in the money supply form a critical part of monetary economics and macroeconomics. It forms a key parameter in monetary policy development, with central banks targeting certain growth levels in the money supply to maintain price stability and support economic growth. Therefore, an understanding of this topic provides valuable insight into broader economic theory and practical policy.

Analyzing Effects of US Money Supply on Economy

US Money Supply plays a critical role in shaping the contours of the nation's economic landscape. While it serves as a vital tool for ensuring economic stability, it also has its caveats.

Role of US Money Supply in Economic Stability

Providing economic stability is one of the primary objectives of every central bank, including the Federal Reserve System in the US. The manipulation of US Money Supply plays a crucial role in ensuring this stability, influencing economic aspects which include, but are not limited to, inflation rates and general growth.

The concept of liquidity preference gives us deeper understanding of how this mechanism works. Liquidity reference is the general behaviourial trend of individuals and institutions to prefer to keep money in its most liquid form possible—that is, in a form that can be used for transactions at any given time.

The Federal Reserve, or the Fed, controls economic stability by manipulating the interest rates and influencing the supply of money. When they see the economy over-heating and inflation creeping up—signs of instability—they may opt to hike the interest rates.

Similarly, during an economic downturn, the Fed might drop the interest rates. Lower interest rates make money cheaper for banks to borrow, meaning that there is more money in circulation to use for lending purposes. As a result, both companies and individuals are more likely to borrow, which kick-starts spending and investment, subsequently stimulating the economy and fostering stability.

Inflation and US Money Supply: A Correlation

One can observe a direct correlation between inflation and the US Money Supply. Generally, an oversupply of money can contribute to inflation, while a diminished money supply can lead to deflation.

The Quantity Theory of Money gives us an equation that can help us perceive this relationship:

Where:

• M stands for the money supply,
• V is the velocity of money (the average frequency a unit of money is spent),
• P represents the price level, and
• T is the transaction level (quantity of transactions).

Examining How US Money Supply Impacts Economic Growth

The growth of an economy is significantly influenced by the US Money Supply, which serves as the backbone of economic activity. By influencing the availability of credit and the cost of borrowing, fluctuations in the money supply can either stimulate or restrain economic growth.

When an economy is in recession, an increase in money supply (by reducing interest rates) can stimulate economic growth. Lower interest rates encourage borrowing, increasing spending, and investment, which, in turn, lead to the creation of jobs and an increase in GDP growth.

In contrast, during times of over-activity or inflation, a decrease in money supply (by hiking interest rates) can have a contractionary effect. Raising interest rates makes borrowing more expensive, thus discouraging spending and investment, which ultimately slows down the economy.

By controlling the money supply and manipulating interest rates, the Fed influences both short-term and long-term interest rates, affecting credit conditions, influencing investment decisions, consumer spending, and business financing costs. Hence, the money supply, controlled via monetary policy, exerts a powerful influence on economic growth.