Money is a collection of liquid assets that is generally accepted as a medium of exchange and for repayment of debt. In that role, it serves to economize on the use of scarce resources devoted to exchange, expands resources for production, facilitates trade, promotes specialization, and contributes to a society's welfare. This theoretical definition serves two purposes: It encompasses new forms of money that may arise as a result of financial innovations related to technological change and institutional developments. It also distinguishes money from other assets by emphasizing its general acceptability as a medium of exchange. While all assets serve as a store of wealth, only a few are accepted as a means of payment for goods and services.
While this definition provides a clear picture of what money is, it does not specify exactly what assets should be included in its measurement. There are several liquid assets such as coins, paper currency, checkable-type deposits, and traveler's checks, which clearly act as a medium of exchange, and definitely belong to its measurement. Several other assets, however, may also serve as a medium of exchange but are not as liquid as currency and checkable-type deposits. For example, money market deposit accounts have check-writing features subject to certain restrictions, and savings accounts can be converted into a medium of exchange with a negligible cost. To what extent such assets should be included in money's measurement is not clear.
As an alternative, economists have proposed defining and measuring money using an empirical approach. This approach emphasizes the role of money as an intermediate target for monetary policy. As Frederic Mishkin pointed out, an effective intermediate target should have three features: It must be measurable, controllable by the central bank, and have a predictable and stable relation with ultimate goals. Thus, an asset should be included in money's measurement if it helps satisfy these requirements. As it appears, evidence on which measure of money has a high predictive power is mixed. A measure that predicts well in one period might not perform well in other times, and a measure that predicts one goal, might not be a good predictor of others.
THE FEDERAL RESERVE SYSTEM'S MONETARY AGGREGATES
The Federal Reserve System (also known as the Fed) has incorporated both the theoretical approach and the empirical approach in constructing its measures of the money supply for the United States. The results are four measures of monetary aggregates, M1, M2, M3, and L, which are constructed using simple summations of some liquid assets. M1 is the narrowest measure and corresponds closely to the theoretical definition of money. It consists of six liquid assets: coins, dollar bills, traveler's checks, demand deposits, other checkable deposits, and NOW (negotiated order of withdrawal) accounts held at commercial banks and at thrift institutions. These assets are clearly money because they are used directly as a medium of exchange.
The M2 aggregate adds to M1 two groups of assets: other assets that have check-writing features such as money market deposit accounts and money market mutual funds shares, and other extremely liquid assets such as savings deposits, small denomination time deposits, overnight repurchase agreements, and overnight Eurodollars. Similarly, the M3 aggregate adds to M2 somewhat less liquid assets such as large denomination time deposits, institutional money market funds, term repurchase agreements, and term Eurodollars. Finally, L is a broad measure of highly liquid assets. It consists of M3 and several highly liquid securities such as savings bonds, short-term Treasury securities, banker's acceptances, and commercial paper.
A potential problem with the simple summation procedure, which underlies the construction of the monetary aggregates, is the assumption that all individual components are perfect substitutes. As William Barnett, Douglas Fisher, and Apostolos Serletis pointed out, this procedure is useful for constructing accounting measures of monetary wealth but does not provide reliable measures of monetary services. As a solution, Milton Friedman and Anna Schwartz proposed weighting individual components by their degree of "moneyness," with the weights varying from zero to unity. Another more rigorous solution proposed by Barnett and his colleagues is based on the application of aggregation and index number theory. Evidence along this line of research suggests that these measures of monetary aggregate are superior to the traditional measures in their predictive contents.
Knowledge of money supply process and information about its behavior are important for two interrelated reasons. First, changes in money growth may have significant effects on the economy's performance. Its short-run variations may affect employment, output, and other real economic variables, while its long-run trend determines the course of inflation and other nominal variables. Second, money supply serves as an important intermediate target for the conduct of monetary policy. As a result, discretionary changes in money growth are instrumental in attainment of economic growth, price stability, and other economic goals.
THE MONEY SUPPLY DETERMINATION PROCESS
Three groups of economic agents play an important role in the process of money supply determination. The first and most important is the Fed, which sets the supply of the monetary base, imposes certain constraints on the set of admissible assets held by banks, and on the banks' supply of their liabilities. Next is the public, which determines the optimum amounts of currency holdings, the supply of financial claims to banks, and the allocation of the claims between transaction and nontransaction accounts. The last is banks, which absorb the financial claims offered by the public, set the supply conditions for their liabilities and allocate their assets between earning assets and reserves subject to the constraints imposed by the Fed. The interaction among the three groups is shaped by market conditions, and jointly determines the stock of money, bank credit, and interest rates.
The level of money stock is the product of two components: the monetary base and the money multiplier. The monetary base is quantity of government-produced money. It consists of currency held by the public and total reserves held by banks. Currency is the total of coins and dollar bills of all denominations. Reserves are the sum of banks' vault cash and their reserve deposits at the Fed. They are the noninterest-bearing components of bank assets, and consist of required reserves on deposit liabilities established by the Fed, and additional reserves that banks deem necessary for liquidity purposes.
The Fed exercises its tight control over the monetary base through open market operations and extension of discount loans. Open market operations are the Fed's authority to trade in government securities. They are the most important instrument of monetary policy and the primary source of changes in the monetary base. An open market purchase expands the monetary base while an open market sale works in the opposite direction. The Fed's control of discount loans is the result of its authority to set the discount rate and limit the level of discount loans through its administration of the discount window.
The money multiplier reflects the joint behavior of the public, banks, and the Fed. The public's decisions about its desired holdings of currency and nontransaction deposits relative to transaction deposits are one set of factors that influence the multiplier. Banks liquidity concerns, and thus their desire to hold excess reserves relative to their deposit liabilities, is another set of factors. The Fed's authority to change the required reserve ratios on bank deposits is the third set of factors. Given the rather infrequent changes in the reserve requirements ratios, the multiplier reflects primarily the behavior of the public, private banks, and the market and institutional conditions.
For example, a decision by the public to increase its currency holdings relative to transaction deposits results in a switch from a component of money supply that undergoes multiple expansions to one that does not. Thus the size of the multiplier declines. Similarly, a decision by banks to increase their holdings of excess reserves relative to transaction deposits reduces bank loans, and causes a decline in deposits, the multiplier, and the money supply. Finally, a decision by the Fed to raise the reserve requirement ratio on bank deposits results in a reserve deficiency in the banking system, forcing banks to reduce their loans, deposit liabilities, the money supply, and the multiplier.
Over the 1980–2005 period, the M1 aggregate grew at an average annual rate of 1.6 percent, while the M2 aggregate rate was 1.9 percent. Nevertheless, the growth rates were not stable. They varied between the low of −14.5 percent and high of 17.9 percent for M1, and between the low of −6.2 percent and high of 10.2 percent for M2. What factors contributed to the long-run growth and short-run fluctuations in the money supply? During the same period, the monetary base grew at an average annual rate of 4.6 percent primarily because of open market operations. Thus changes in monetary base and open market operations are the primary source of long-run movements in the money supply. For shorter periods, however, changes in the money multiplier may have also contributed to the fluctuations in the money supply.
see also Federal Reserve System ; Money
Barnett, William A., Fisher, Douglas, and Serletis, Apostolos (1992, December). Consumer theory and the demand for money. Journal of Economic Literature 4, 2086–2119.
Chrystal, K. Alec, and McDonald, Ronald (1994, March–April). Empirical evidence on recent behavior and usefulness of simple sum and weighted measures of the money stock. Federal Reserve Bank of St. Louis Review 76, 73–109.
Friedman, Milton, and Schwartz, Anna J. (1970). Monetary statistics of the United States: Estimates, sources, and methods. New York: Colombia University Press for the National Bureau of Economic Research.
Mishkin, Frederic S. (2004). The economics of money, banking, and financial markets (7th ed.). Boston: Pearson.
Thornton, Daniel L. (2000, January–February). Money in a theory of exchange. Federal Reserve Bank of St. Louis Review 82, 35–60.
What It Means
The term money supply refers to the total amount of money circulating in the economy. There are different ways of measuring the money supply, depending on how money is defined. In the United States three definitions of money are commonly used; they are called M1, M2, and M3.
M1 represents the narrowest view of the money supply. M1 includes only those forms of money that can be used to purchase goods and services immediately without any substantial restrictions. The measure of M1 is determined by calculating the dollar amount of currency (bills and coins issued by the government), traveler’s checks, and checking-account balances at a given time.
M2 includes M1 plus most savings accounts, money-market accounts (savings accounts that usually require larger minimum balances and place other restrictions on withdrawal of money, in exchange for higher interest rates), and CDs (certificates of deposit, a form of interest-bearing account that has time restrictions regarding when it can be cashed in) valued at under $100,000.
M3 is the broadest definition of the money supply commonly used in the United States. In addition to all the forms of money included in M2, M3 also measures some larger forms of assets and CDs of over $100,000. M3 provides a figure for all of the money available in an economy, though it is possible that a broader definition of money could be devised.
Economists, financial professionals, and government policymakers pay close attention to the size of the money supply in order to understand and make decisions about matters that are important to an economy’s health, such as interest rates (the fees charged to borrow money), inflation (the general rising of prices), and economic growth. A country’s central bank (such as the U.S. Federal Reserve System) increases or decreases the money supply in order to regulate the economy.
When Did It Begin
For most of European and American history, coins were made of precious metals such as gold and silver, and paper money directly corresponded to an amount of gold or silver for which it could be exchanged. From the 1790s through the early twentieth century, the United States, with some exceptions, tied the value and amount of its money in circulation to the amount of precious metals it possessed. Therefore, the money supply was equivalent to the supply of gold and silver, and regulation of the money supply required ensuring that the country had sufficient amounts of precious metals to back up variations in the amount of money it minted. There was no central authority, however, to monitor the money supply until 1913, when the Federal Reserve System (commonly called the Fed) was created to guard against the failure of banks and ensuing financial panic. Thereafter, the Fed regulated all the other banks in the country and thus had the power to control the money supply directly.
During the Great Depression (a severe worldwide economic downturn that took place from 1929 through the end of the 1930s), as U.S. paper money lost its value, large numbers of people exchanged their bills for gold or silver. As a result, the country’s gold stockpiles dropped considerably, and the government began to impose strict limitations on the ability to exchange money for gold. By the 1960s the connection between U.S. paper currency and precious metals was virtually eliminated, and the nation ceased using silver in the manufacture of its coins. This meant that U.S. dollars had become “fiat money,” or money whose value rested entirely on the government’s assurance that it was valuable. By this time one of the Fed’s primary jobs was to ensure that U.S. money did not lose its value (which can happen because of inflation, or the rising of prices across the economy). The Fed affects inflation and attempts to influence economic growth through monetary policy, or the increasing or decreasing of the money supply.
More Detailed Information
Depending on economic conditions, the Fed may choose to expand or limit the amount of money in circulation. Because the U.S. Treasury Department is actually responsible for printing money and minting coins, the Fed cannot change the amount of money in circulation by simply ordering that money be printed or not printed. Instead it uses various tools for increasing or decreasing the amount of money that banks can lend to individuals and businesses. Banks are able to “create” money through lending; thus, they are responsible for the size of the money supply.
For instance, imagine that Joe Smith deposits $10,000 in his bank. The bank may be required by law to place 10 percent of Joe’s deposit (or $1,000) in reserve, to be used if account holders want to withdraw cash from their accounts. The bank can loan the remaining $9,000 to some other individual or business in order to make a profit by charging interest (a fee for the use of the money). Say that Jane Brown borrows $9,000 from the same bank to start a hot-dog-vending business. When she spends the $9,000 to acquire a vending cart and a stock of hot dogs, buns, and condiments from a supplier called Hot Dog World, Hot Dog World will likely deposit that $9,000 in its own bank. Hot Dog World’s bank will then set aside the required 10 percent ($900) and then make $8,100 available for a loan.
This process continues, theoretically, until the potential of that original $10,000 has been exhausted. If every bank and every borrower behaved according to the pattern established above, Joe Smith’s original $10,000 deposit would ultimately result in an addition of $90,000 to the money supply (using M1 as the definition of the money supply for the sake of this example).
Any given $10,000 does not always result in $90,000. Sometimes a borrower might simply pocket part of his or her loan, and banks do not always lend out the maximum amount that the law allows them to lend. Still, economic theory tells us that when a bank has excess money available to lend, we should expect the money supply to grow by multiples of that available amount. Therefore, when the Fed wants to increase or decrease the money supply, it does so by changing the amount of money banks have available to lend.
For decades after the Great Depression, U.S. economic policy was built on the ideas of the British economist John Maynard Keynes (1883–1946), who emphasized fiscal policy (taxing and government spending) over monetary policy (controlling the money supply). This approach is thus often called Keynesian economics. But beginning in the 1960s, the American economist Milton Friedman (1912–2006) argued that government mismanagement of the money supply had caused the Depression and that Keynesian fiscal policies were creating further problems for the American economy. When the U.S. economy saw both prices and unemployment rise in the 1970s (an unprecedented phenomena that came to be known as “stagflation” because of the presence of inflation and a stagnant economy), many economists turned to Friedman’s views, which had predicted just such an eventuality.
Under President Ronald Reagan (in office 1981–89), Friedman’s ideas dominated U.S. economic policy. Chief among them was the idea that a government should not interfere in any part of the economy except the money supply, which was the key to controlling inflation. This idea, called monetarism, continues to influence government leaders and academics, but most economists today focus less exclusively on the money supply in their ideas about how best to regulate the economy.
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.