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U.S. Money Supply

What is meant by the money supply? The term itself implies that a certain amount of money exists at any given time, even though the quantity may be unknown. In truth there can be no meaningful measure of the quantity because it is continually varying as a function of demand.

The Fed has its own arbitrary measures of the money supply, which it once used to help guide its monetary policy decisions. Basically it defines money as the total of cash in circulation and deposit liabilities of banks and thrifts. At one time it set targets for the growth of the money supply. Now it largely ignores its own measures because it has found little correlation between them and its major policy objectives � limiting inflation and unemployment.

Monetary Aggregates

The Fed defines three monetary aggregates which consist mainly of the cash in circulation plus the deposit liabilities of banks and money market mutual funds. The narrowest definition, M1, includes only the transaction deposits of banks. A broader definition, M2, adds savings accounts and small term deposits at banks plus retail money market funds. The broadest definition, M3, adds large term deposits, institutional money market funds, repurchase agreements, and eurodollars. The concept behind these three categories is that they represent decreasing levels of activity, M1 being the most active.

Note that the Fed's definition of the money supply includes only what the non-bank sector holds. Thus the reserves of banks, i.e. vault cash and deposits at the Fed, though a part of the monetary base, are not included in the monetary aggregates. That means when a bank spends for itself, it increases the money supply. When it receives payments from the public such as interest on loans, the money supply decreases.

Bank Lines of Credit as Money

An important shortcoming of the Fed's definition is that it ignores lines of credit which can be exercised at the pleasure of borrower. Firms often hold substantial lines of credit on their banks, which they can use at a moment's notice. Likewise consumers have lines of credit with their credit cards that are just as useful for purchases as checking accounts or the currency in their wallets.

When someone uses a credit card in a purchase, he automatically expands the money supply. The seller receives a new deposit in his account, which increases the total of demand deposits in the banking system -- until the buyer pays off the loan. The result is that consumers who roll over their credit card loans rather than paying them off have increased the money supply on their own initiative by hundreds of billions of dollars. In effect, the money supply is substantially larger and less measurable than the Fed's definition.

The Quantity Theory of Money

Economists regularly use the term money supply without defining it. A notable example is the equation of exchange in the quantity theory of money.

MV = PT

This relates the money supply, M, and the velocity of money, V, to the average price level, P, and the total number of transactions, T. The equation is simply an identity, meaning it is true by definition. Yet it is often used to "prove" that the average price level increases with the quantity of money. But an identity can say nothing about causal relations. The only thing we can know is the product MV, which equals the national income, PT, which itself is only roughly measurable. The quantity of money, M, remains undefined and unknowable.

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