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Money Supply

Evidence along this line of research suggests that these Fed’s control of discount loans is the result of its author-
measures of monetary aggregate are superior to the tradi- ity to set the discount rate and limit the level of discount
tional measures in their predictive contents. loans through its administration of the discount window.
Knowledge of money supply process and information The money multiplier reflects the joint behavior of
about its behavior are important for two interrelated rea- the public, banks, and the Fed. The public’s decisions
sons. First, changes in money growth may have significant about its desired holdings of currency and nontransaction
effects on the economy’s performance. Its short-run varia- deposits relative to transaction deposits are one set of fac-
tions may affect employment, output, and other real eco- tors that influence the multiplier. Banks liquidity con-
nomic variables, while its long-run trend determines the cerns, and thus their desire to hold excess reserves relative
course of inflation and other nominal variables. Second, to their deposit liabilities, is another set of factors. The
money supply serves as an important intermediate target Fed’s authority to change the required reserve ratios on
for the conduct of monetary policy. As a result, discre- bank deposits is the third set of factors. Given the rather
tionary changes in money growth are instrumental in infrequent changes in the reserve requirements ratios, the
attainment of economic growth, price stability, and other multiplier reflects primarily the behavior of the public,
economic goals.
private banks, and the market and institutional condi-
tions.
THE MONEY SUPPLY
For example, a decision by the public to increase its
DETERMINATION PROCESS
currency holdings relative to transaction deposits results
Three groups of economic agents play an important role
in a switch from a component of money supply that
in the process of money supply determination. The first
undergoes multiple expansions to one that does not. Thus
and most important is the Fed, which sets the supply of the size of the multiplier declines. Similarly, a decision by
the monetary base, imposes certain constraints on the set
banks to increase their holdings of excess reserves relative
of admissible assets held by banks, and on the banks’ sup- to transaction deposits reduces bank loans, and causes a
ply of their liabilities. Next is the public, which deter-
decline in deposits, the multiplier, and the money supply.
mines the optimum amounts of currency holdings, the Finally, a decision by the Fed to raise the reserve require-
supply of financial claims to banks, and the allocation of
ment ratio on bank deposits results in a reserve deficiency
the claims between transaction and nontransaction
accounts. The last is banks, which absorb the financial in the banking system, forcing banks to reduce their loans,
deposit liabilities, the money supply, and the multiplier.
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 HISTORICAL TREND
the Fed. The interaction among the three groups is shaped Over the 1980–2005 period, the M1 aggregate grew at an
by market conditions, and jointly determines the stock of average annual rate of 1.6 percent, while the M2 aggregate
money, bank credit, and interest rates. rate was 1.9 percent. Nevertheless, the growth rates were
The level of money stock is the product of two com- not stable. They varied between the low of –14.5 percent
ponents: the monetary base and the money multiplier. and high of 17.9 percent for M1, and between the low of
The monetary base is quantity of government-produced –6.2 percent and high of 10.2 percent for M2. What fac-
money. It consists of currency held by the public and total tors contributed to the long-run growth and short-run
reserves held by banks. Currency is the total of coins and fluctuations in the money supply? During the same
dollar bills of all denominations. Reserves are the sum of period, the monetary base grew at an average annual rate
banks’ vault cash and their reserve deposits at the Fed. of 4.6 percent primarily because of open market opera-
They are the noninterest-bearing components of bank tions. Thus changes in monetary base and open market
assets, and consist of required reserves on deposit liabili-
operations are the primary source of long-run movements
ties established by the Fed, and additional reserves that in the money supply. For shorter periods, however,
banks deem necessary for liquidity purposes.
changes in the money multiplier may have also con-
The Fed exercises its tight control over the monetary tributed to the fluctuations in the money supply.
base through open market operations and extension of
discount loans. Open market operations are the Fed’s SEE ALSO Federal Reserve System; Money
authority to trade in government securities. They are the
most important instrument of monetary policy and the
BIBLIOGRAPHY
primary source of changes in the monetary base. An open Barnett, William A., Fisher, Douglas, and Serletis, Apostolos
market purchase expands the monetary base while an (1992, December). Consumer theory and the demand for
open market sale works in the opposite direction. The money. Journal of Economic Literature 4, 2086–2119.

520 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION