Money Supply

The supply or stock of money consists of all the money held by the nonbank public at any point of time. Money is defined as the generally accepted medium of exchange, i.e., whatever is generally accepted in paying for goods and services and repaying debt. It must, however, be emphasized that an economist's notion of money differs from the conventional usage of the term.

Commonly, people recognize currency (consisting of notes and coins) as money, since currency in one form or another has been used as a medium of exchange since ancient times. In moden day advanced societies, cash is still "king," but currency is not the dominant part of what economists consider money. The other key component of money is the amount of checkable deposits in the banking system, as people can write checks on their accounts (deposits) to pay for goods and services or to repay debt. The third, and a relatively minor, component of the money supply is the amount of outstanding traveler's checks. The sum of currency held by the nonbank public, checkable deposits, and traveler's checks yield a measure of money supply officially known as the Ml (or money aggregate) measure of money supply in the United States.

It may come as somewhat of a surprise to many people that credit cards are not listed above as being part of the money supply. After all, don't most people use credit cards in numerous ordinary transactions? Some individuals even refer to credit cards as "plastic money." The main reason for excluding credit cards is fairly straight forwardusing a credit card is equivalent to buying on credit, at least temporarily. In other words, payment by credit cards is inherently different from payment by cash or checks.

To properly understand how the money supply is measured by the federal monetary authorities, one needs to understand the functions of money. There are:

- medium of exchange;
- measure or standard of value;
- standard of deferred payment; and
- store of value.

DIFFERENT MEASURES OF MONEY SUPPLY

Money as defined above yields the most narrowly defined measure of money supply known as M1. This Ml measure of money supply, most closely corresponds to the ordinary definition of money (i.e., something that is commonly accepted in payment of goods and services).

THE CENTRAL MONETARY AUTHORITY.

Every country has a central bank that monitors the money supply and almost always determines the level of money supply in the economy. In the United States, the Federal Reserve System serves as the central bank of the country. The Federal Reserve, commonly referred to as the Fed, uses three different measures of money supplyMl, M2, and . M2 and M3 measures of money supply build on the narrowly defined Ml measure by successively broadening the money supply measure. Thus, Ml is the narrowest measure of money supply, M2 is broader than Ml, and M3 is the broadest measure.

In order to understand why the Federal Reserve System uses successively broader measures of money supply, one has to go back to the ordinary definition of money and then consider what else can be converted into ordinary money with minimum difficulty. The example of savings account deposits can be used to demonstrate why the Ml measure of money supply is broadened. Remember, the narrow Ml definition of money supply includes checkable deposits, but not savings account deposits. The reason for excluding savings account deposits is the inability of a savings account to be directly used in making payments, unlike a checking account. However, with just a phone call to one's bank, one can transfer money from savings into checking and then make the payment by writing checks on the checking account. Alternatively, one can drive to bank and withdraw money in cash from his or her savings account, thus converting resources in the savings account into ordinary money. As this illustrates, there is very little difference between the "moneyness" of checkable and savings deposits. Savings account deposits are therefore called near-money. Not considering items that are considered near-money, means that M1 does not properly reflect the extent of true money supply in the economy. The Federal Reserve thus coined broader measures of money supply (M2 and M3) to capture the characteristics of money in items other than those included in the Ml measure of money supply.

THE Ml MEASURE OF MONEY SUPPLY. As pointed out earlier, Ml is the narrowest measure of money supply and closely corresponds to the common definition of money. Ml monetary aggregate can be defined as follows: Ml = Currency + Demand deposits + Other checkable deposits 4- Traveler's checks Currency simply consists of notes (bills of different denominations) and coins. Currency currently accounts for less than one-third of the Ml money supply in the United States. Checkable deposits make up nearly two-thirds of the Ml money supply. The checkable deposits category itself is normally split into demand deposits and other checkable deposits, while both these components of checkable deposits can be used to write checks to make payments for goods and services, there is an important distinction between demand and nondemand checkable deposits. Demand deposits are normally maintained by businesses and they carry no interest payments. They are termed demand deposits because the entire amount in a demand deposit is payable to the deposit holder or a designated person on demand. Moreover, some banks charge a service fee from holders of demand deposits, fees that are often waived if the amount in a demand deposit exceeds a certain level. The category "other checkable deposits" include different kinds of checkable deposits that pay interest to the deposit holders NOW (negotiated order of withdrawal) accounts, su-per-NOW accounts and ATS (automatic transfer from savings) accounts. Therefore, if nondemand checkable deposits can be used both to write checks and to + Overnight repurchase agreements + Overnight Eurodollars + Consolidation adjustment Basically, six additional assets are added to the narrow measure of money supply known as Ml (the seventh item is merely an adjustment), these items will be briefly discussed below.

Savings deposits are maintained by households and individuals. These deposits pay a varying interest based on the balance in an account. Money can be withdrawn from these accounts without penalty. The major inconvenience of a savings account is that checks can't be written on them. Banks have found a way around this inconvenience by permitting automatic transfer of funds from a savings account to pay for checks written on the checking account maintained by the individual. These are called ATS (automatic transfer from savings) accounts. Because of this, ATS accounts are included as part of the Ml money supply. Only the non-ATS portion of savings account deposits are added to the Ml measure when broadening it into the M2 monetary aggregate.

Time deposits are commonly known as certificates of deposit. A certificate is issued for a fixed period of time with a specified maturity date and a specified interest rate. Certificates of deposits that are for less than $100,000 are called small-denomination time deposits. Unlike the household savings accounts, certificates of deposits (CDs) have a prescheduled maturity date and a financial penalty for early withdrawal of funds, making somewhat illiquid. In order to make certificates of deposits more liquid, banks have begun issuing CDs that are negotiable. Instead of suffering a severe financial penalty, a holder of a negotiable CD can sell it on the secondary market without penalty. Before 1961, bank certificates of deposits were nonnegotiable they could not be sold to someone else and had to be redeemed, if necessary, from the issuing bank at a substantial penalty. In 1961, Citibank introduced the first negotiable CDs in large denominations ($100,000 or above). Negotiable CDs are now issued by almost all major commercial banks.

Money market deposit accounts are interest bearing accounts where the interest paid on balances in the accounts depends on the interest rate prevailing in the money market. The money market itself consists of short-term financial instruments (those that have maturity periods of one year or less). The key feature of a money market instrument is that its yield reflects the current interest rate and inflation in the economy. A money market deposit thus allows the holder of the account to participate in the money market. Usually, large sums are needed to participate in the money market directly, which means most individual investors are not able to do so. Banks and other financial institutions, through money market accounts, provide an individual one way to participate in the money market. These often is a minimum investment that an individual must make to use the money market route, although it is less than other investment options.

Most money market deposit accounts also carry limited check-writing privileges and thus resemble interest bearing checking accounts, to a degree. Therefore, many academic scholars in the field believe that money market accounts should be part of the M1 measure of money supply. However, at the current time, listed as a component of M2, not Ml.

Money market mutual funds are mutual funds that invest in money market instruments. For reasons described above, individuals have difficulty in directly participating in the money market. Opening a money market deposit account at a bank is one way to participate in the money market. Buying shares of a money market mutual fund is another. Money market mutual funds basically pool individual investors' resources and invest them in money market instruments. After subtracting costs, they distribute the gains from the investments to those who contributed to the pool of funds through the purchase of shares. Like money market deposit accounts at banks, most money market mutual funds also provide limited check writing privileges. Checks frequently cannot be written for less than a certain minimum, and a substantial amount of money is initially required to open an account with a money market mutual fund. These restrictions are generally quite similar to those that apply to money market deposit accounts at banks.

Repurchase agreements are essentially short-term loans backed by U.S. Treasury bills as collateral. Usually, the maturity period of a repurchase agreement is less than two weeks, although it can be as short as overnight. A repurchase agreement transaction can be illustrated as follows: A large corporation has some idle cash and a bank wants to borrow some funds overnight to make up for the shortfall in the amount of required reserves that it must have at the Federal Reserve. Assume that the corporation uses $10 million to buy Treasury bills from the bank, which agrees to repurchase Treasury bills the next morning at a price slightly higher than the corporation's purchase price. The additional price that the bank pays is a way of paying interest on the overnight use of the $10 million. Should the bank not buy back the Treasury bills that the corporation is holding, the latter can sell those bills to recover its loan. Transferred Treasury bills thus serve as a collateral, which the lender receives if the borrower does not pay back the loan.

Repurchase agreements are a relatively new financial instrument. They have been in existence only since 1969. However, they constitute an important source of funds for banks, where large corporations are considered the most important lenders. Because of extremely short maturity, overnight repurchase agreements are considered very liquid the instrument turns back into cash the very next day. However, because it is less liquid than currency or checkable deposits, it is included in the M2 measure.

The term Eurodollar originates from the fact that U.S. dollars, at one time, were deposited at banks in Europe by certain individuals and countries. The tradition of Eurodollar deposits was first established when the Soviet Union deposited U.S. dollars in Europe rather than in the United Statesit wanted the security that the U.S. dollar provided, along with interest income from its deposits, without exposing the cash to the uncertainty that a deposit in the United States may have entailed. Depositing U.S. dollars outside the United States is no longer confined to EuropeU.S. dollars are now deposited in a variety of locations, including Hong Kong, Singapore, Sydney, and Tokyo. For this reason, Eurodollars are sometimes also referred to as overseas dollars.

Eurodollar deposits are specially attractive to American banks. The advent of Eurodollar deposits was one of the major reasons why so many banks based in the United States have open branches in foreign countries. They can borrow Eurodollar deposits from their own foreign branches or from other banks when they need additional funds. Inclusion of Eurodollar deposits in M2 is a recognition on the part of the Federal Reserve System that the Eurodollar deposits abroad can be converted into dollar holdings in the United States, affecting the U.S. money supply.

The consolidation adjustment is merely a statistical adjustment applied to the M2 measure to avoid double counting. It is not a fundamental component of the M2 monetary aggregate in the SAME sense that other elements are. The kind of double counting the consolidation adjustment is designed to avoid can be illustrated with the help of an examplethe M2 consolidation adjustment subtracts short-term repurchase agreements and Eurodollars being held by money market mutual funds, because they are already included in the balances of money market mutual funds.

One can assert that the M2 measure of money supply is a somewhat lower on the liquidity scale, compared to the Ml measure, which is the most liquid. Assets that are added to the Ml aggregate to arrive at the M2 measure are items that are the most easily and most frequently transferred into checking accounts or can otherwise be converted into cash quickly.

The M3 measure of money supply further broadens the M2 monetary aggregate by adding additional assets that are less liquid than those included in Ml and M2. Formally, M3 is defined as follows: M3 = M2 + Large-denomination time deposits + Money market mutual fund shares (institutional) + Long-term Repurchase agreements + Term Eurodollars + Consolidation adjustment

Many of the items that are added to the M2 measure of money supply to arrive at the M3 monetary aggregate are similar in name to those added to the Ml measure to arrive at the M2 measure, except that the maturity periods associated with the Ml measures are shorter. The five items that are added to the M2 measure to arrive at the M3 measure are briefly discussed below.

Certificates of deposits issued in denominations of $100,000 or above are called large-denomination time deposits. These are like small-denomination time deposits (issued in denominations of less than $100,000), with a scheduled maturity date and a specified interest rate. However, large-denomination certificates of deposits are usually negotiable CDs that can be sold in the secondary market before they mature. Thus, large-denomination negotiable CDs serve as an alternative to investing in Treasury bills for corporate treasurers who have idle funds to invest for a short time.

Money market mutual fund shares that are added to M2 to arrive at M3 are the same as those that are added to the Ml measure to arrive at the M2, with a minor difference. Money market mutual fund shares held by institutions also are included when the M3 measure of money supply is calculated, whereas only money market mutual fund shares held by noninstitu-tions investors were included when the M2 measure of money supply was constructed.

Repurchase agreements that have maturity periods of more than one night are called long-term repurchase agreements. Thus, long-term repurchase agreements also facilitate borrowing and lending in which Treasury bills are essentially used as collateral. By nature, long-term repurchase agreements are less liquid than overnight repurchase agreements.

Like long-term repurchase agreements, term Eurodollars have a maturity period greater than one night. While the maturity period of a term Eurodollar can vary, a majority of them mature in a few weeks. Obviously, term Eurodollars are less liquid than overnight Eurodollars. That is why term Eurodollars are included only in M3 and not in M2.

An adjustment, similar to that made to the M2 measure of money supply, is made to the M3 monetary aggregate to avoid double counting.

In sum, one can consider the M3 monetary aggregate to be lower on the liquidity scale than the M2 measure, when all components of M3 are considered together.

As was discussed above, the M2 and M3 measures of money supply are, successively, lower on the liquidity scale than Ml. While Ml closely corresponds to the ordinary notion of money, M2 and M3 capture the moneyness in assets not included in Ml. To monitor the supply of money in the economy, the Federal Reserve looks at all three measures of the money supply but tends to focus on the M2 measure. There is a considerable debate among economists regarding the value of the Fed's emphasis on the M2 monetary aggregate.

While growth rates of all three measures of money supply do have a tendency to move together, there also exist some glaring discrepancies in the movements of these monetary aggregates. For example, according to the M1 measure, the growth rate of money supply did not accelerate between 1968 and 1971. However, if the M2 and M3 measures are used as the guide, a different story emergesthey show a significant acceleration in the growth rate of money supply. Because of this kind of divergent behavior, the battle to find the true measure of money supply continues. Often a weighted average of monetary aggregatesone that captures the moneyness in all assets included in M2 and M3 (remember, Ml is already money in the strict sense of the term)has been suggested to arrive at the true measure of the money supply.

As was mentioned earlier, in every free market economy the money supply is controlled by the nation's central bank, the chief monetary authority for the country. A central bank is known by different names in different countriesoften, even the adjective I 'central" may be missing. For example, in the United States, the central bank is known as the Federal Reserve System; in England, it is known as the Bank of England; and in Germany, it is called the Bundesbank.

The Federal Reserve System in the United States uses three different methods to control and manipulate the nation's money supply. However, before discussing these methods, it will be useful to understand the players that participate in increasing or decreasing the levels of monetary aggregates.

All definitions of money supply underscore the fact that deposits at commercial banks, savings and loan associations, credit unions, and mutual savings banks (collectively known as depository institutions) are an integral part of the money supply. Why are depository institutions involved in the money supply process? Depository institutions, profit by taking deposits from individuals and businesses and making loans to a variety of borrowers. The difference between what they earn from the loans made and the amount paid to depositors (in additional to the operating costs) constitutes the basis for profits to the depository institutions. This logic will induce banks and other depository institutions to loan out as much of depositors' funds as possible. However, the Federal Reserve has put a restriction on this behaviorthe depository institutions are required to keep a fraction of the deposits in reserves at the Federal Reserve. Thus, the depository financial institutions can only lend out the excess reservesreserves (vault cash and cash deposits at the Federal Reserve) over and above the reserves required, by law, to be kept at the Federal Reserve Bank.

In manipulating the money supply, it is the level of the excess reserves that the Federal Reserve attempts to influence to affect the growth rate of the nation's money supply. To illustrate this, let us assume that through some mechanism the Fed is able to increase the amount of excess reserves in the banking system. Banks, faced with the extra resources, want to lend them prudently to earn interest on loans made. Further, assume that loans are made by simply creating deposits (which are part of the money supply) in borrowers' names. Creating additional deposits results in an increase in the money supply. While the preceding logic may appear like an academic concoction, this is what happens in the real world. The only question that remains to be answered is as to how the Federal Reserve manipulates the level of excess reserves in the banking system.

There are three instruments available to the Federal Reserve Bank that it can use to manipulate the excess reserves in the banking system and thus the level of money supplythe reserve requirement ratio, the discount rate and open market operations. THE RESERVE REQUIREMENT RATIO. The reserve requirement ratio is the legal ratio determined by the Federal Reserve (within limits established by the Congress) that it requires of the depository institutions in calculating the minimum reserves they must keep to conform to the federal banking law. Thus, if the Fed increases the reserve requirement ratio, it automatically reduces the amount of excess reserves in the banking system. This can be explained as follows. Suppose, a bank has $100 million deposits and the reserve requirement ratio is 10 percent. Further, assume that it has $18 million in reserves. Since the bank is required to keep a minimum of $10 million in required reserves (the 10 percent reserve requirement ratio applied to $100 million in deposits), it has an excess reserve of $8 million. If the Federal Reserve increases the reserve requirement ratio from 10 percent to IS percent, would then have to keep $15 million in legal reserves. This leads to a decrease in the level of excess reserves from $8 million to $3 million. A decrease in the amount of excess reserves reduces the ability of the bank to make loans, to create additional deposits and to increase the money supply. In this example, the bank started from positive excess reserves and then increased the reserve requirement ratio. If it had started from zero excess reserves and then increased the reserve requirement ratio, the levels of deposits and money supply would be forced to fallbanks caught with deficient minimum legal reserves would have to reduce the level of deposits, consistent with available reserves.

The Federal Reserve can both lower and raise the reserve requirement ratio to affect money supply. However, raising the legal reserve ratio is especially powerful when the banking system has no excess reserves.

Despite the apparent potency of the reserve requirement ratio as an instrument of money supply manipulations, it is seldom utilized by the Federal Reserve in influencing money supply. A change in the reserve requirement ratio is a legal change and it is not advisable to change the rules of the game frequently. Thus, while the reserve requirement ratio may be utilized in a financial emergency, the Federal Reserve does not use the ratio to manipulate the nation's money supply on a regular basis.

The discount rate is the interest rate the Federal Reserve Bank charges banking institutions for the loans it makes to them. The Federal Reserve was initially created as a lender of last resortits function was to lend to banks in need of funds through discounting banks' holdings of, say, Treasury bills. Essentially, the Fed made loans to banks with Treasury bills serving as collateral.

Of course, if banks can borrow from the Federal Reserve at a low rate of interest and lend to its borrowers at higher interest rates, it will be clearly profitable for them. By lowering the discount rate, the Federal Reserve lowers the cost of borrowing and increases banks' willingness to borrow. This can potentially increase the level of excess reserves in the banking system and, consequently, the money supply. Raising the discount rate can have the opposite effect on the level of excess reserves and the money supply.

While the discount rate can potentially be used to influence the levels of excess reserves and money supply in the economy, the Federal Reserve does not use this method to induce increased borrowing by banks. The Federal Reserve dislikes profit-based borrowing by the depository institutionsthat is, borrowing at a lower interest rate from the Fed and then lending at higher interest rates to banks' customers. The Federal Reserve Bank does not mind need-based borrowing by banks (when banks, due to some unanticipated factors, fall short of funds). Even then, Federal Reserve closely monitors any bank that borrows from the Fed too frequently.

The preceding discussion suggests that the Federal Reserve does not like to use the discount rate as an instrument to manipulate the level of money supply in the economy on a regular basis (by manipulating the level of excess reserves in the banking system). The Fed, however, does utilize this instrument in an indirect way in manipulating money supplyit uses the discount rate as a signalling device. When the Federal Reserve Bank lowers the discount rate, it signals to the banking system and the financial market that it is in favor of increasing money supply. When the Fed increases the discount rate, it sends out the opposite message. In fact, banks often take the Fed's announcement of the discount rate change quite seriouslyif the Federal Reserve raises the discount rate, for example, major banks follow up by raising their prime rates (the rate a bank charges its best customers).

Open market operations are the third and the most frequently used instrument by the Federal Reserve in manipulating the money supply. In open market operations, the Federal Reserve Bank uses market forces to manipulate the level of the excess reserves and thus the money supply in the economy.

In open market operations, the Federal Reserve either buys Treasury securities (bills and bonds) from banks or sells Treasury securities to them. When the Federal Reserve sells Treasury bonds to banks, the Fed receives cash in exchange for bondsthe excess reserves in the banking system go down and thus the money supply will, potentially, go down also. The opposite is the case when the Federal Reserve sells Treasury securities to the banking system.

The Federal Reserve uses open market operations to manipulate the nation's money supply on a regular basisthe open market operations are considered the main instrument of monetary policy (increasing or decreasing the money supply with a view to influence the state of the economy).

While the Federal Reserve is fairly successful in manipulating the money supply, there are some uncertainties regarding the magnitude of a monetary aggregate or the exact time when the increase in the money supply materializes after the Fed initiates the process of expanding the money supply. For example, the Federal Reserve increases the level of excess reserves in the banking system to increase the money supply. However, banks are reluctant to loan (and thus to increase the money supply) because of lack of creditworthy borrowers or their desire to wait for better opportunities. Thus, the Federal Reserve's attempt to increase money supply is frustrated. Despite this uncertainty, the Fed is able to determine changes in the money supply since banks have to report periodically to the Federal Reserve.

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