Money Supply

MONEY SUPPLY

Money supply is the total quantity or volume of money circulating in the economy. Some economists define it narrowly as the total value of coins, paper currency, traveler's checks, and checking account balances at any given time. This definition of the money supply is called "M1." The broader definition of money supply, "M2," adds savings accounts and money market mutual funds. Money supply can also be defined as "M3," which combines M1 and M2 and adds other types of savings deposits and money market funds. At the end of 1998 the total amount of M2 in the United States economy was about $4.4 trillion, while M3 was at $6 trillion.

At about the same time as the United States was being founded, economists were discovering that an economy's money supply had a direct effect on prices and economic growth. The Coinage Act of 1792 defined the value of the U.S. dollar in terms of silver and gold, but after major gold discoveries in the 1830s and in 1849 gold began to replace silver as the standard by which the dollar was defined. The first and second Banks of the United States (1791–1811 and 1816–1836, respectively) tried to control the money supply by making sure that U.S. banks had enough gold on hand to back up the paper bills that they printed and issued. The money supply, however, grew enormously during the American Civil War (1861–1865), when the government began printing "greenbacks" that weren't backed up by gold or silver. By 1879 the dollar was back on the gold standard, and when world gold supplies increased between 1897 and 1914, so did the U.S. money supply.

When the Federal Reserve was created in 1913 it was given the power to control the money supply by increasing or shrinking the amount of currency circulating in the economy. Despite this power, in the early 1930s the Federal Reserve failed to increase the money supply enough to keep the economy from contracting. The resulting Great Depression (1929–1939) led economists who supported the Keynesian economic theory to reject the traditional idea that an economy's health depended on how the money supply was managed. They instead believed that economic growth had to be managed through fiscal policies such as taxation and government spending.

The combined inflation and recession of the 1970s (called "stagflation") convinced a new generation of economists that ineffective government attempts to "fine-tune" the economy through fiscal policy and inconsistent changes in the money supply did not work. Because of these new economic theories in the 1980s, the Federal Reserve began to change the way it reacted to inflation. When inflation rose one percent, the Federal Reserve would raise interest rates 1.5 percent rather than the less aggressive 0.75 percent it would have applied in earlier years. This bolder approach to controlling the money supply was much more effective in controlling inflation. As a result, even though the economy boomed from 1982 through the 1990s inflation remained mild.

See also: Bank of the United States (First National Bank), Bank of the United States (Second National Bank), Federal Reserve System, Gold Standard, Greenbacks, Money