Money Supply (Encyclopedia of Business and Finance)
Money is a collection of liquid assets that is generally accepted as a medium of exchange and for repayment of debt. In that role, it serves to economize on the use of scarce resources devoted to exchange, expands resources for production, facilitates trade, promotes specialization, and contributes to a society's welfare (Thornton, 2000). This theoretical definition serves two purposes: It encompasses new forms of money that may arise as a result of financial innovations related to technological change and institutional developments. It also distinguishes money from other assets by emphasizing its general acceptability as a medium of exchange. While all assets serve as a store of wealth, only a few are accepted as a means of payment for goods and services.
While this definition provides a clear picture of what money is, it does not specify exactly what assets should be included in its measurement. There are several liquid assets, such as coins, paper currency, checkable-type deposits, and traveler's checks, which clearly act as a medium of exchange and definitely belong in its measurement. However, several other assets may also serve as a medium of exchange but are not as liquid as currency and checkable-type deposits. For example, money market deposit accounts have check-writing features subject to certain restrictions, and savings accounts can be converted into a medium of exchange with a negligible cost. To what extent such assets should be included in money's measurement is not clear.
As an alternative, economists have proposed defining and measuring money using an empirical approach. This approach emphasizes the role of money as an intermediate target for monetary policy. As Mishkin (1997) points out, an effective intermediate target should have three features: It must be measurable, be controllable by the central bank, and have a predictable and stable relation with ultimate goals. Thus, an asset should be included in the measurement of money if it satisfies the above requirements. Evidence is mixed on which measures of money have a high predictive power. A measure that predicts well in one period might not perform well at other times, and a measure that predicts one goal might not be a good predictor of others.
The Federal Reserve System (the Fed) has incorporated both the theoretical approach and the empirical approach in constructing its measures of the money supply for the United States. The results are four measures of monetary aggregates1, M2, M3, and Lhat are constructed using simple summations of some liquid assets. M1 is the narrowest measure, corresponding closely to the theoretical definition of money. It consists of six liquid assetsoins, dollar bills, traveler's checks, demand deposits, other checkable deposits, and NOW accounts held at commercial banks and at thrift institutions. These assets are clearly money because they are used directly as a medium of exchange. The M2 aggregate adds to M1 two groups of assets: (1) other assets that have check-writing features, such as money market deposit accounts and money market mutual funds shares, and (2) other extremely liquid assets, such as savings deposits, small-denomination time deposits, overnight repurchase agreements, and overnight Eurodollars. Similarly, the M3 aggregate adds to M2 somewhat less liquid assets, such as large-denomination time deposits, institutional money market funds, term repurchase agreements, and term Eurodollars. Finally, L is a broad measure of highly liquid assets. It consists of M3 plus several highly liquid securities, such as savings bonds, short-term Treasury securities, bankers' acceptances, and commercial paper.
A potential problem with the simple summation procedure, which underlies the construction of the monetary aggregates, is the assumption that all individual components are perfect substitutes. As Barnett, Fisher, and Serletis (1992) point out, this procedure is useful for constructing accounting measures of monetary wealth but does not provide reliable measures of monetary services. As a solution, Friedman and Schwartz(1970) have proposed weighting individual components by their degree of "moneyness," with the weights varying from zero to unity. Another more rigorous solution proposed by Barnett and colleagues (1992) is based on the application of aggregation and index number theory. Evidence along this line of research (Chrystal and McDonald, 1994) suggests that these measures of monetary aggregate are superior to the traditional measures in their predictive contents.
Knowledge of the money-supply process and information about its behavior are important for two interrelated reasons. First, changes in money growth may have significant effects on the economy's performance. Its short-run variations may affect employment, output, and other real economic variables, while its long-run trend determines the course of inflation and other nominal variables. Second, money supply serves as an important intermediate target for the conduct of monetary policy. As a result, changes in money growth may be instrumental in attaining economic growth, price stability, and other economic goals.
Three groups of economic agents play an important role in the process of money-supply determination. The first and most important is the Fed, which sets the supply of the monetary base and imposes certain constraints on the set of admissible assets held by banks and on the banks' supply of their liabilities. Next is the public, which determines the optimum amounts of currency holdings, the supply of financial claims to banks, and the allocation of the claims between transaction and nontransaction accounts. The last is banks, which absorb the financial 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 the Fed. The interactions among the three groups are shaped by market conditions and jointly determine the stock of money, bank credit, and interest rates (Brunner, 1989).
The level of money stock is the product of two components: the monetary multiplier and the monetary base. The monetary base is the quantity of government-produced money. It consists of currency held by the public and total reserves held by banks. Currency is the total of coins and dollar bills of all denominations. Reserves are the sum of banks' vault cash and their reserve deposits at the Fed. They are the non-interest-bearing components of bank assets, consisting of required reserves on deposit liabilities established by the Fed and additional reserves that banks deem necessary for liquidity purposes.
The Fed exercises its tight control over the monetary base through open-market operations and extension of discount loans. Open-market operations, which are the Fed's authority to trade in government securities, are the most important instrument of monetary policy and the primary source of changes in the monetary base. An open-market purchase expands the monetary base, whereas an open-market sale works in the opposite direction. The Fed's control of the discount loans results from its authority to set the discount rate and limit the level of discount loans through its administration of the discount window.
The money multiplier reflects the joint behavior of the public, banks, and the Fed. The public's decisions about their desired holdings of currency and nontransaction deposits relative to transaction deposits are one set of factors that influence the multiplier. Banks liquidity concerns, and thus their desire to hold excess reserves relative to their deposit liabilities, are another set of factors. The Fed's authority to change the required reserve ratios on bank deposits constitutes the third set of factors. Given the rather infrequent changes in the reserve-requirement ratios, the multiplier primarily reflects the behavior of the public and private banks as well as market and institutional conditions.
For example, a decision by the public to increase its currency holdings relative to transaction deposits results in a switch from a component of money supply that undergoes multiple expansion to one that does not. Thus, the size of the multiplier declines. Similarly, a decision by banks to increase their holdings of excess reserves relative to transaction deposits reduces bank loans, causing a decline in deposits, the multiplier, and the money supply. Finally, a decision by the Fed to raise the reserve-requirement ratio on bank deposits results in a reserve deficiency in the banking system, forcing banks to reduce their loans, deposit liabilities, the money supply, and the multiplier.
Over the 1980-1999 period, the M1 and M2 aggregates grew at average annual rates of 5.5 and5.7 percent, respectively. However, the growth rates were not stable. They varied between the low of 3.5 percent and the high of 16.9 percent for M1, and between the low of 0.4 percent and the high of 11.4 percent for M2. What factors contributed to the long-run growth and short-run fluctuations in the money supply? During the same time period, the monetary base grew at an average annual rate of 7.5 percent, due primarily to open market operations. Thus changes in the monetary base and open-market operations are the primary source of long-run movements in the money supply. For shorter time periods, however, changes in the money multiplier may also have contributed to the fluctuations in the money supply.
Barnett, William A., Fisher, Douglas, and Serletis, Apostolos. (1992). "Consumer Theory and the Demand for Money." Journal of Economic Literature 4 (December): 2086-2119.
Brunner, Karl (1989). "Money Supply." In The New Palgrave: Money, ed. John Eatwell, Murray Milgate, and Peter Newman. New York: W.W. Norton (pp. 263-267).
Chrystal, K. Alec, and McDonald, Ronald. (1994). "Empirical Evidence on Recent Behavior and Usefulness of Simple Sum and Weighted Measures of the Money Stock." Federal Reserve Bank of St. Louis Review 76 (March-April): 73-109.
Friedman, Milton, and Schwartz, Anna J. (1970). Monetary Statistics of the United States: Estimates, Sources, and Methods. New York: Colombia University Press.
Mishkin, Frederic S. (1997). The Economics of Money, Banking, and Financial Markets, 5th ed. Reading, MA: Addison-Wesley.
Thornton, Daniel L. (2000). "Money in a Theory of Exchange." Federal Reserve Bank of St. Louis Review 82 (January-February): 35-60.
Money Supply (Encyclopedia of Business)
- DIFFERENT MEASURES OF MONEY SUPPLY
- WHICH MONETARY AGGREGATE DOES THE FED USE?
- MONEY SUPPLY AND THE BANKING SYSTEM
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 modem 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 bank 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. At the end of 1998, the M1 measure of money supply was estimated at about $1,115 billion, only 42 percent of which was in currency; 47 percent was in checkable deposits and less than 1 percent was in traveler's checks.
It may be somewhat surprising that credit cards are not considered part of the money supply. After all, 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 forwardsing a credit card is equivalent to buying on credit, at least temporarily. In other words, payment by credit card is inherently different from payment by cash or check.
MONEY AND ITS KEY FUNCTIONS
To properly understand how the money supply is measured by the federal monetary authorities, one needs to understand the functions of money. While money is defined as anything accepted in payment for goods and services or repayment of debts, it serves several additional functions, such as unit of account and store of value. All three major functions of money are briefly discussed below.
MEDIUM OF EXCHANGE.
The definition of money itself refers primarily to the medium of exchange as its key characteristic. Certainly, money in the form of currency or checks serves this function. One can appreciate the contribution of money in facilitating exchanges if one looks into the consequences of doing without moneyhat is, depending on a bartering system. Imagine a person working at a farm and being paid in corn that he helped to produce. Further, say this worker does not like to eat corn and has to buy food and nonfood items (such as, clothing, shoes, books, etc.) to satisfy his and his family's needs from his earnings at the farm. He will have to find individuals who will provide him with rice, potatoes, shirts, tennis shoes, children's books, etc. in exchange for his corn. There must always be a double coincidence of wants for a transaction to be consummated. One can easily see that, in the absence of money, the farm worker will have to spend quite a bit of time just converting his earnings in corn into the items he actually wants to consume. When money is introduced into the picture, the farm worker gets paid in dollars. He then takes his earnings in dollars and buys different items with his income. People who receive the farm worker's dollars also do the same. Thus, the need to find an individual, for example, who wants to exchange shirts for corn is avoided. Use of money as a medium of exchange reduces waste and inefficiency by eliminating much of the time spent in exchanging goods and services. As a result, money also promotes specialization, with different individuals specializing in different trades or professions without having to worry about how to trade services or output to assemble all the items that their incomes can afford. The need for money is so strong that all societies, except those that are extremely primitive, invent some form of money. Money has taken the form of strings of beads (used by American Indians), cigarettes (used in prisoner-of-war camps), gold coins (used by Romans,) and traveler's checks used by modern tourists.
UNIT OF ACCOUNT.
The second important function of money is to serve as a unit of accountust as we measure weight in pounds or height in inches, the values of goods and services are expressed in terms of money. For example, a shirt costs $45 at a department store, and a crystal ashtray costs $90 at the same store. Thus, the ashtray is twice as expensive as the shirt. The convenience of money can again be seen by contrasting it with a barter economy scenario. Assume that there are only 10 commodities in the economy. With 10 commodities, one must know 45 prices (economic worth of each commodity expressed in terms of the 9 other commodities). However, if money is used to quote values of the 10 commodities, one needs to know only 10 prices to accomplish the same objective that the barter system will do with 45 prices. As the number of commodities increases, the complexity of the barter system multiplies immensely. For example, with 1,000 items, nearly half a million prices will be needed in the barter system. Most supermarkets have many more than 1000 items total nightmare even for a mathematically inclined shopper. Money thus performs an important function as a unit of account by reducing the transactions costs due to a much smaller number of prices that have to be considered.
STORE OF VALUE.
Money also functions as a store of value, although not in all circumstances. Serving as a store of value means that wealth can be held in terms of money for future useo be spent on items or to be passed on to heirs. Money is not the only asset that functions as a store of value. Many assets, such as stocks, bonds, real estate, and gold, can also be used as a store of value. Money has a minor advantage over competing assets in one respectt is already in the form that can be spent, while the others first have to be converted into money before being spent. In this sense, money is the most liquid of all assets that can be used to store wealthtocks and bonds are less liquid than money, but more liquid than real estate. However, money as a store of value has two major disadvantages. First, other assets may yield returns that are far greater than moneyay, one individual earns 20 percent a year on stocks and only 3 percent on his checking account. Thus, wealth will multiply faster when held in assets other than money. Secondly, during periods of rapid inflation, money may not serve as a useful store of wealth. The decline in the usefulness of money as a store of wealth depends on the rate of inflation. Inflation erodes the purchasing power of money. If price levels double in one year, the stored money will buy only half as much the next year. There are real world examples in history where money became worthless rather quickly. Germany after World War I provides an example of an extreme inflationary environmenthe inflation rate sometimes exceeded 1000 percent per month. If a worker did not spend his or her income in the morning, it lost much of its value by the evening.
As the German example illustrates, money is almost useless as a store of value in a highly inflationary environment. Even with a 10-15 percent annual inflation rate, money is not considered a good store of value. Because of these difficulties, money is not widely used as a store of value for a prolonged period of timether assets, despite their relative lack of liquidity, have an edge over money.
DIFFERENT MEASURES OF MONEY SUPPLY
Money as defined above yields the most narrowly defined measure of money supply known as Ml. 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 supplyl, M2, and M3. M2 and M3 measures of money supply build on the narrowly defined M1 measure by successively broadening the money supply measure. Thus, M1 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 M1 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 Ml 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 M1 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. M1 monetary aggregate can be defined as follows:
Currency simply consists of notes (bills of different denominations) and coins. Currency currently accounts for less than one-third of the M1 money supply in the United States. Checkable deposits make up nearly two-thirds of the M1 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 non-demand checkable deposits. Demand deposits are normally maintained by businesses and 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" includes different kinds of checkable deposits that pay interest to the deposit holdersOW (negotiated order of withdrawal) accounts, super-NOW accounts and ATS (automatic transfer from savings) accounts. Therefore, if non-demand checkable deposits can be used both to write checks and to earn interest, why maintain checkable deposits in the demand deposit form? The answer lies in a restriction associated with non-demand checkable depositshile balances in demand deposits are payable on demand, checks written on balances in non-demand checkable deposits are negotiated orders of withdrawal. That is, the payment may be delayed for a while, depending on the amount of withdrawal. Even though most people have never experienced this delay in payments from an interest bearing non-demand checking account, it can happen in extreme circumstances. Because businesses deal in larger amounts of money, they cannot entertain this uncertainty and have to maintain demand deposits.
Traveler's checks constitute a very small fraction of the M1 money supplyess than 1 percent of the total Ml. Traveler's checks can be used to make payments even outside one's home country, as the issuer of the traveler's checks guarantees payments to the individual or business that receives them (so long as they are properly signed). One can thus consider traveler's checks as checks with added features designed to increase widespread acceptance.
One can now see how all three components of the M1 measure of money supplyurrency, checkable deposits and traveler's checksre clearly money in the ordinary sense of the term, as they can be directly used in payment of goods and services. One warning about money as it is defined abovet is not universally acceptable (especially beyond a nation's borders). To make the currency universally acceptable within a country, the government of that country usually provides its currency with legal backing. In the United States, for example, every denomination of paper currency carries the following notice: "THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE." Thus, declining to accept a genuine Federal Reserve note is literally in violation of the federal law. However, this doesn't mean that U.S. currency would automatically have value in foreign countries, nor does it mean that the currency of other nations is valid in the United States. In fact, stores in U.S. cities bordering Canada often state that Canadian money is not accepted without violating any rules.
THE M2 MEASURE OF MONEY SUPPLY.
The M2 measure of money supply is made broader than the Ml monetary aggregate by adding additional items that fall under the near-money category. M2 is formally defined as follows:
Basically, four 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 savings accounts 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 is added to the M1 measure when broadening it into the M2 monetary aggregate.
SMALL-DENOMINATION TIME DEPOSITS.
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 household savings accounts, certificates of deposits (CDs) have a predetermined maturity date and a financial penalty for early withdrawal of funds, making CDs somewhat less liquid. 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 nonnegotiablehey could not be sold to others 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.
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 shortterm 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. There is often 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 FUND SHARES (NONINSTITUTIONAL).
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.
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 examplehe 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 M1 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
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:
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 four items that are added to the M2 measure to arrive at the M3 measure are briefly discussed below.
LARGE-DENOMINATION TIME DEPOSITS.
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 (INSTITUTIONAL).
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 noninstitutional investors were included when the M2 measure of money supply was constructed.
OVERNIGHT AND TERM REPURCHASE AGREEMENTS.
Repurchase agreements are essentially shortterm 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 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 time to maturity, overnight repurchase agreements are considered very liquidhe 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 M3 measure.
Repurchase agreements that have maturity periods of more than one night are called term repurchase agreements. Thus, term repurchase agreements also facilitate borrowing and lending in which Treasury bills are essentially used as collateral. By nature, term repurchase agreements are less liquid than overnight repurchase agreements. Term repurchase agreements are included in M3 as well.
OVERNIGHT AND TERM EURODOLLARS.
The term Eurodollar originates from the fact that U.S. dollars were at one time 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 Statest 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 Europe.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 that so many banks based in the United States opened 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 M3 is recognition on the part of the Federal Reserve System that Eurodollar deposits abroad can be converted into dollar holdings in the United States, thereby affecting the U.S. money supply.
Like 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. Term Eurodollars are included in M3 as well.
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.
WHICH MONETARY AGGREGATE DOES THE FED USE?
As was discussed above, the M2 and M3 measures of money supply are successively lower on the liquidity scale than M1. While M1 closely corresponds to the ordinary notion of money, M2 and M3 capture "moneyness" 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 Ml 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 emergeshey show a significant acceleration in the growth rate of the 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 aggregatesne that captures the moneyness in all assets included in M2 and M3 (remember, Ml is already money in the strict sense of the term)as been suggested to arrive at the true measure of the money supply.
CONTROLLING THE NATION'S 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 countriesften, even the adjective "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.
MONEY SUPPLY AND THE BANKING SYSTEM
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. Depository institutions are in the money supply business because they profit by taking deposits from individuals and businesses and making loans to a variety of borrowers. The difference between what they earm 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 behaviorhe depository institutions are required to keep a fraction of the deposits in reserves at the Federal Reserve. Thus, depository financial institutions can only lend out the excess reserveseserves (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 earm 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 supplyhe 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) required 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 15 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 fallanks 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.
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 resortts 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 institutions, i.e., 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 supplyt uses the discount rate as a signaling 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 seriouslyf 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).
THE OPEN MARKET OPERATIONS.
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 bondshe 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 basishe 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).
THE MONEY SUPPLY UNCERTAINTY.
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.
SEE ALSO: Federal Reserve System
[Anandi P. Sahu, Ph.D.]
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Mishkin, Frederic S. The Economics of Money, Banking and Financial Markets. 5th ed. Reading, PA: Addison-Wesley, 1998.
Ritter, Lawrence S., William L. Silber, and Gregory F. Udell. Principles of Money, Banking and Financial Markets. 9th ed. Reading, PA: Addison-Wesley, 1997.