The money supply is a key factor in modern developed economies, it consists of the entire stock of currency and other liquid instruments that circulate in the economy at a particular point in time. There is no one universal way to measure it because its amount may vary depending on the kind of definition used and on which classes of financial assets are considered to be money.
As said before, it is one of the most important factors in the economic analysis of every economic system, it is in fact considered by economists as a key variable to a complete understanding of the macroeconomic policy.
The money supply is highly regarded by economists because, as said before it can have a great impact on the overall economy
For example, an increase in the supply of money typically leads to a lowering of the interest rates, which in turn will help to generate more investments and put more money in the hands of consumers, thereby stimulating demand and spending.
Businesses will likely respond to this increase in aggregate demand by ordering more raw materials and by increasing production in order to satisfy the demand, and in order to increase production, businesses will have to hire more workers.
Of course, even the opposite can occur if the money supply falls or when its growth rate declines.
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The role of Central Banks
The great effect that the changes in monetary base have on the general economy has increased the power of the institutions that are in charge of implementing Monetary Policy, Central Banks.
They are institutions that in most countries operate independently from the Government, and since the introduction and adoption by major economies of the fiat monetary system (after Nixon shock) have the objective to implement the monetary policy through the management of money supply, and have a specific mandate that must be at the basis of their everyday operations, for example, the ECB has to maintain price stability by setting key interest rates and by controlling the union’s money supply.
The fiat monetary system (where the term “fiat”, which derives from the Latin “fieri”, an arbitrary act or decree), is a monetary system in which the value of a currency is not based on any physical commodity but is instead allowed to fluctuate dynamically against other currencies on the foreign-exchange markets.
It is a relatively recent introduction, in fact as said before, prior to the Nixon shock of 1971, the model that was generally used was the Bretton Woods System, which established a system of payments based on the U.S. dollar, and defined all currencies in relation with to the dollar which was itself convertible into gold.
How Central Banks affect Money Supply?
Central Banks, as said before, have the power to influence Money Supply and manage it in order to realize the goals of Monetary Policy. They are able to do it in three main ways:
1- Modify reserve requirements
Modifying reserve requirements is sometimes considered as money creation by commercial banks.
In fact, under the fractional-reserve banking system used throughout the world, where banks can make loans to borrowers while holding as reserve an amount that is only a fraction of the bank’s deposit liabilities. This ratio is usually determined by the Central Bank and can heavily influence the amount of money that commercial banks can loan to consumers or businesses.
The reserve requirement is a ratio between deposit liabilities and reserves that the bank must maintain.
Thanks to the mechanism of fractional-reserve, if the Central Bank increases the amount of money that can be lent in relation to a certain amount of reserves can lead to an increase in money supply because the loans made by banks, when drawn and spent, for the most part, finish up as a deposit in the banking system, which is counted as a part of the money supply.
After putting aside a part of these deposits (determined by the CB) as mandated bank reserves, the balance is available for the making of further loans by the bank. The continuing of this process multiple times is called the multiplier effect.
2- Conducting Open Market Operations
Central Banks can use Open Market Operations to influence the money supply, they consist of purchases of government securities, such as government bonds or treasury bills, by the central bank.
These operations can lead to a rise in the price of such securities due to the increased demand, and therefore to a fall in interest rates. The new funds available to commercial banks will increase their ability to lend more, and as a result of the multiplier effect coming from fractional-reserve banking, loans, and bank deposits can go up by many times the initial injection of funds into the banking system.
On the other hand, when the central bank “tightens” the money supply, it means that it sells securities on the open market, drawing liquid funds out of the banking system, then the prices of such securities will fall as a result of the increased supply, which leads interest rates to rise.
This phenomenon has a multiplier effect too.
3- Change of Short Term Interest
Another instrument available to central banks in order to influence Money Supply is the ability to change short-term interest rates.
This instrument can have a big impact too, in fact, by lowering (or raising) the discount rate that commercial banks pay on short-term loans made by the central bank, we can see an increase (or decrease) of the liquidity of money.
Lower short-term interest rates tend to increase the money supply and to boost economic activity, while at the same time, it may risk fueling inflation, therefore central banks that decide to intervene in the economy by using short-term interest rates must be careful not to lower them for too long.
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