The money supply process
What you are about to read may make you feel uneasy, on edge, afraid even.
You may have
trouble believing it.
Not everyone knows what about to tell you.
Many who do try not to think too much
It's a closely guarded secret, known only to those who have studied macroeconomics.
For the weak minded, faint of heart, and yes, the world.
Our interest will be confined to an economy where the
monetary authority is a central bank.
An economy's monetary authority is the institution that is responsible for controlling the money supply.
So what is a central bank?
It's a lending agency that has the authority to print money (issue currency).
And by lending more/less money out than previously, the central bank increases/decreases the
This is how the money supply process works when a central bank is the monetary authority.
in the 2nd quarter of 2009 the central bank has loaned out $400 billion.
Say it decides to $500 billion in
the 3rd quarter, i.e. lend $100 billion more than it was lending.
Well, unlike commercial banks, the
central bank is not dependent on deposits to make loans.
If it decides to lend more,
it has the authority
to print currency to do so.
(Note that the central bank could write a check, which could be exchanged
for currency or used by a commercial bank in which it was deposited to meet that bank's reserve
So, the bank may have $100 billion in currency (or more) lying around in its vaults when it
decides to lend $100 billion.
But if not, it can turn on the printing presses.
Either way, when it lends
$100 billion more than it was lending,
it will be
$100 billion of currency (or checks as good
as currency) into the economy.
And so the money supply will increase.
the other hand, if the
central bank decides to lend less money than it was lending (when borrowers pay off loans, the central
bank just puts some of that money aside), it will be taking money out of circulation = the money supply
will go down.
And as wild as that may seem, that is the nuts and bolts of the money supply process in an
economy whose monetary authority is a central bank.
By the way, as far as I know, every country has a
Let's think a little more closely about how the amount of money in circulation, the money supply,
Recall that something is money if it is a medium of exchange, that is, generally accepted
as payment for goods and services.
Consequently, the money supply is usually taken to be M1, although
sometimes M2 (or even M3) is used.
Here are the definitions of M1, M2, and M3 (from the Statistical
Supplement to the Federal Reserve Bulletin:
M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions;
(2) travelers checks of nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by
depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of