Money Supply
What is Money Supply?
The money supply is the total amount of money circulating in an economy, including cash and checkable deposits.
Central banks influence it through open market operations, the reserve requirement, and the discount rate. Common measures are M1 (most liquid) and M2 (broader). Changes in the money supply affect interest rates and aggregate demand.
Money Supply: a worked example
The central bank buys $200 million of government bonds from commercial banks while the required reserve ratio is 10%, giving a multiplier of 1 / 0.10 = 10. Bank reserves rise by $200 million, all of it excess, so lending can expand deposits by $200 million x 10 = $2,000 million, or $2 billion. Buying the same bonds from households instead puts $200 million into deposits, of which $20 million is held as required reserves and $180 million is excess, supporting $180 million x 10 = $1,800 million of further deposits on top of the original $200 million. Both routes reach the same $2 billion. If banks park half their excess reserves instead of lending, the actual expansion lands well short of that ceiling.
The mistake students make with money supply
A frequent misstep is reporting that a $200 million bond purchase from commercial banks raises the money supply by $200 million on the spot. That trade swaps one asset for another on the bank's books, lifting reserves without creating a single new deposit, so the money supply moves only once the bank lends. The opposite error is treating maximum expansion as a forecast. Multiplier arithmetic gives a ceiling that assumes every excess dollar is lent and every loan returns to a bank, and cash holding or idle reserves keep the real increase below it.
Money Supply questions
How does the Fed increase the money supply?
The central bank most often buys government bonds on the open market, which credits reserves to banks and lets them expand lending. Lowering the discount rate or the interest paid on reserves also encourages lending, and cutting the required reserve ratio raises the money multiplier. A $200 million bond purchase under a 10% reserve ratio can support up to $2 billion of new deposits across the banking system.
Does depositing cash in a bank increase the money supply?
Depositing cash does not raise the money supply by itself. Currency held by the public and checkable deposits both count in M1, so moving $500 from a wallet into a checking account leaves the total where it was. Growth arrives afterward, when the bank lends the portion it is not required to hold and the borrower's spending lands as a deposit somewhere else.
What is the difference between the money supply and the monetary base?
The monetary base counts currency in circulation plus reserves held by banks, the money a central bank creates directly. The money supply measured as M1 counts currency held by the public plus checkable deposits, most of which commercial banks created by lending. One bond purchase raises the base dollar for dollar but raises M1 by a multiple, which is why the base is called high powered money.
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