Understanding the Determinants of the Money Supply and Its Impact on Economic Policies

The concept of money supply is often misunderstood, particularly when it comes to its exact definition and the factors that determine it. This article aims to clarify these nuances and explore how the money supply influences economic policies.

What Determines the Money Supply?

The term 'money supply' refers to the total amount of money available in an economy. However, it's important to note that different definitions of money supply exist, which can lead to varying interpretations of the total amount of money in circulation.

For some, the money supply in circulation includes only bills and coins held by individuals and entities outside the possession of the Central Bank. For others, it includes money held in commercial bank reserves and treasury reserves.

A broader definition of the money supply includes bank deposits, which are often created through the lending process. This expanded definition is crucial for understanding the relationships between central banks, commercial banks, and the broader economy.

Base Money: The Foundation of the Money Supply

Base money, also known as high-powered money or reserve money, is a subset of the money supply that forms the foundation. It includes physical currency (notes and coins) and virtual money stored in Central Bank ledgers but owned by entities outside the Central Bank.

Physical Money: This refers to the money in circulation as notes and coins.

Virtual Money: This is the digital money held in the Central Bank's accounts but accessible by commercial banks and other entities. This includes reserves and vault cash.

Unfortunately, some definitions of base money do not include Treasury Reserves, which are funds held by the Central Bank but owned by the Treasury. This oversight can limit the proper understanding of economic interpretations and policy recommendations.

The Relationship Between Spending and the Money Supply

The money supply is primarily determined by the amount of spending in the economy. When income is spent, existing money continues to circulate. When borrowed money is spent, new money is put into circulation. Therefore, the total amount of spending is the amount of money in circulation.

The money supply includes currency deposits and liquid financial assets that can quickly be turned into cash. Short-term variations in the money supply can be significantly influenced by monetary policy actions:

Expansionary Monetary Policy: This policy is used to stimulate economic activity by reducing interest rates, making it cheaper to borrow and spend. Contractionary Monetary Policy: This policy is employed to curb inflation by increasing interest rates, making borrowing more expensive.

In the long term, the growth of the economy tends to cause the money supply to expand at a similar rate, matching the rising demand and spending.

Conclusion

Understanding the determinants of the money supply is crucial for economic policy-making. Different definitions of the money supply can have significant implications for economic interpretations and policy recommendations. By clarifying these concepts, we can better understand how monetary policies influence spending and economic growth.

For a deeper understanding of these concepts, I recommend reading my books: Enlightened Capitalism: A Keynes Primer 2nd edition and A Critique of MMT.

Keywords: Money Supply, Base Money, Economic Policy, Spending, Central Bank