Money Supply is the current total supply of money in circulation in the whole economy of the country. There are three measures of money supply referred to as M1, M2, and M3.
M1 is a narrow measure of money's function as a medium of exchange. It includes all coins, publicly held currency, traveler's checks, and money account balances for checking accounts, credit union accounts, NOW accounts, and automatic transfer service accounts.
M2 is a broader measure that also reflects money's function as a store of value. M2 includes M1 plus savings and small time deposits, overnight repossessions at commercial banks, and non-institutional money market accounts. M2 is a key economic indicator which helps forecast inflation.
M3 is an even broader measure that includes close substitutes for money. M3 includes M2 plus large time deposits, repossessions of maturity greater than one day at commercial banks, and institutional money market accounts.
Money Supply has a powerful effect on economic activity.
An increase in money supply stimulates increased spending because it puts more money in the hands of consumers which makes them feel wealthier, stimulating them to increase their spending.
A decrease in money supply or a decrease in the growth of money supply, results in decreased spending because there is less money in the hands of consumers, stimulating them to decrease their spending. This causes a decline in economic activity and can cause disinflation (reduced inflation) or deflation (falling prices)
Federal Reserve policy has a dramatic impact on the money supply through its impact on bank deposits, bank reserves, and currency levels.
The Federal Reserve can cause an increase in bank reserves by buying U.S. Treasury securities because the seller of the Treasury security deposits the check in a bank, increasing the seller's deposit and when the bank deposits the Federal Reserve check at its district Federal Reserve bank, it increases the banks reserves. When the Federal Reserve sells Treasury securities, it causes the opposite effect, lowering the purchaser's deposits and the bank's reserve. There is also a leverage effect in play here because the bank can lend money at a multiple of its reserves on deposit. The multiplier effect depends on the required reserve ratio on deposits. A low required-reserve ratio raises the value of the multiplier.
Money Supply is directly linked to inflation, as shown by the Monetary Exchange Equation:
velocity * money supply = real GDP * GDP deflator
velocity = the number of times per year that money changes hands
real GDP = GDP - GDP deflator
GDP deflator = measure of inflation (calculated by the BEA)
Thus if money supply grows faster than real GDP, inflation (increase in general level of prices and a fall in the purchasing power of money) results since velocity stays relatively stable.
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