The money supply is the amount of currency available to consumers and businesses to make payments as well as money held in checking and savings accounts. The money supply is made up of different components.
In the U.S., the "monetary base" is the sum of currency in circulation plus banks' reserve balances held at the Federal Reserve. There are two types of "M" used when speaking about money supply:
- M1: This includes the most liquid forms of money, including cash held by the public plus deposits available for immediate withdrawal—i.e., checking and debit accounts—held at depository institutions such as commercial banks and credit unions.
- M2: This includes M1 plus less liquid sources of cash, such as savings deposits, small-denomination time deposits (less than US$100,000), and money held in money market mutual funds.
The Fed publishes monthly money supply data in its Aggregate Reserves of Depository Institutions and the Monetary Base and Money Stock Measures. The money supply and the monetary base are linked by reserves, namely cash held in bank vaults and bank deposit balances held at regional Federal Reserve banks.
Central Bank Control Over The Monetary Base
According to Daniel Thornton, economist emeritus at the Federal Reserve Bank of St. Louis, the Fed has "complete" control over the size of the monetary base but not the overall money supply. "One major reason for this is banks can choose to hold the additional base money (i.e., deposit balances with the Federal Reserve banks) supplied by the Fed as excess reserves," Thornton writes.
The main way the Fed controls the monetary base is through its open market operations (OMOs), in which it buys and sells securities for its own account with banks and other large institutions. If the Fed wants to increase the monetary base, for example, it buys securities. The proceeds from the sale are deposited in the buyer's account at the Fed, which adds to the bank's reserves and increases the monetary base. Conversely, if the Fed wants to reduce the monetary base, it sells securities, thus decreasing the bank's balance at the Fed.
Waning Importance Of The Money Supply
"Over time," according to the Fed, the money supply has lost some of its importance as a guide to conduct monetary policy. Previously, the Fed says, the size of the money supply "exhibited fairly close relationships with important economic variables" such as economic growth and inflation. "Over recent decades," however, those relationships "have been quite unstable."
While the Federal Open Market Committee, the Fed's monetary policymaking body, still takes money supply data into consideration while conducting monetary policy, it only uses it as "part of a wide array of financial and economic data."
The money supply is the amount of cash available to consumers and businesses to make payments as well as money held in checking and savings accounts. There are different components to the money supply, but there's only one that the Federal Reserve has "complete" control over, the monetary base.
The Fed can control the base's size by buying securities from banks, which gives the banks more money, while selling securities has the opposite effect. Although the Fed still considers the size of the money supply in conducting monetary policy, it no longer has the strong correlation with economic growth and inflation that it once did.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…