Define Real Money Supply


The consequences of unfettered printing of paper moneywere deemed undesirable in several places in the previous Topic.Now we turn to an analysis of the effects of excess money growth.The discussion focuses on the determinants of the price level.It will be recalled that the price level is the average ofall prices in the economy, taken as a percentage of that sameaverage in some earlier base period. And inflation is the growthor increase, on average, of prices---the annual rate of inflationis the year-to-year percentage growth of the price level.

Low money velocity is usually associated with recessions and contractions. According to the Quantity Theory of Money, inflation depends on the money supply and its velocity. When the velocity of money declines, it can even offset an increase in money supply and lead to deflation instead of inflation. In macroeconomics, the money supply (or money stock) refers to the total volume of money held by the public at a particular point in time in an economy. Low money velocity is usually associated with recessions and contractions. According to the Quantity Theory of Money, inflation depends on the money supply and its velocity. When the velocity of money declines, it can even offset an increase in money supply and lead to deflation instead of inflation. Definition: Money supply refers to the amount of domestic currency that circulates in a national economy during a specified period.Money supply includes cash, coins, and money held in savings and checking accounts for short-term payments and investments. Supply of Money. The supply of money in an economy is controlled by its central bank, for example, Fed in the US. The Fed may change the money supply by using open market operations or by changing reserve requirements. Demand and Supply Curve. The demand and supply curve for money can be represented as follows.

Prices measure the amount of money that has to be given up toobtain units of the goods in question. Correspondingly, the pricelevel measures the amount of money that has to be given up to buya unit of the average good in the economy---or, roughly, a unit ofaggregate output. The amount of output one must give up to obtaina unit of money is therefore equal to the reciprocal of the pricelevel. The inverse of the price level thus represents what a unitof money is worth in terms of goods, or the value of money.So the question of what determines the price level boils down tothe question of what determines its reciprocal or the value of money.

It is natural to think of the value of money as determinedin the same way as the value of any other good or service---by thesupply and demand for it. Analysis of the supply and demand formoney differs slightly from that of the supply and demand for typicalgoods produced in the economy because money holdings are a stockwhile goods produced are flows. This difference is not substantivehowever---we simply measure the stock of money held by the public onthe horizontal axis of our supply and demand graph instead of thequantity of a good purchased per unit time. The determination of the price level can thus be analyzed with respect to Figure 1. The nominal money stock is on the horizontal axis and the value of money---whichequals 1/P where P is the price level---is on the vertical one.

Define Real Money Supply

Ideally, we conceive of the stock of money as the amountof liquidity in the economy. You will recall that liquidity is anattribute possessed by assets that represents the ease with whichthey can be converted into a predictable amount of cash for makingexchange. Most assets possess some degree of liquidity but only cashis completely liquid. Because assets possess varying degrees ofliquidity, we can only imperfectly measure the quantity of liquidityin the economy. The two most common measures of the quantity ofliquidity---that is, the money supply---are M1, which equals cash plus demand deposits, and M2, which equalscash plus both demand and time deposits. For the remainderof this Lesson we will simply think in terms of a conceptual stockof money that we will call M which can be approximately measured by either M1 or M2.

The supply curve in Figure 1 is thus a vertical line positionedto the right of the vertical axis by an amount equal to the existingstock of nominal money balances in circulation. When the centralbank increases the money supply this vertical line shifts rightward.The demand for nominal money stock, given by the curve DD, is downward sloping to the right like any demand curve. It is not, however, a straight line. The reason is that people make their decisions on how much money to hold on the basis of the real, not the nominal, quantity.


Suppose that the private sector holds a given nominal quantityof money M0. The amount of transactions that can be made with that quantity of nominal money balances will depend on the price level---if the price level were to double, the existing nominal level of money holdings would finance only half of the previous volume oftransactions. People would require twice as big a nominal moneystock to provide the same level of transactions services. In otherwords, the amount of transactions services provided by money willdepend on the real stock of money, not the nominal stock.

People will thus decide on an appropriate level of real moneyholdings and then accumulate the stock of nominal money balancesneeded to provide those real holdings. Thus, given desired realmoney holdings, the nominal quantity of money demanded will varyin direct proportion with the price level and in inverse proportion with the nominal value of money.

Since the public decides on a desired real money stock, M/P, the rectangular area under DD associated with each given level of M will be a constant equal to 1/P times M, which will equal M/P. The demand curve for nominal money balances DD will thus be a rectangular hyperbola. A given rise in M will cause P to rise, and 1/P to fall, in the same proportion as that rise in M as we move along the curve.

If the central bank creates the quantity of money M0, the equilibrium price level will be P0. If it increases the quantity of money to M1, the price level will rise to P1and the value of money will fall to 1/P1.

Having established the shape of the demand curve for nominalmoney holdings, we must now think about what will determine itslevel---that is, the level of desired real money holdings. Oneobvious factor will be the real flow of transactions, which canbe roughly measured by the level of real income. A rise in realincome, and the associated increase in the transactions demandfor money, will thus shift DD to the right as shown in Figure 2. A second factor will be the cost of holding money relative toother assets.

People hold money because it saves time and labour effort thatwould otherwise have to be devoted to arranging barter and checkingother people's credit ratings. That effort could have been devotedto producing goods and services for consumption and investment. Butthe choice of how much money to hold, and how much labour to thereby make available for other uses, will depend on how much income willbe sacrificed by holding additional money instead of other assets.Assuming that money holdings earn no interest, that sacrifice will bethe interest that could have been earned by holding bonds and otherassets instead of that additional money.Bonds and other assets that are fixed in nominal value willearn interest at, say, i percent. Real assets such as cars and TV sets will earn a return equal to, say, r percent. As we saw in the previous Lesson,Interest Rates and Asset Values, the difference betweenthe interest rates on nominal assets such as bonds and the returnon real assets such as cars and TV sets will be the expected rateof inflation. This is given by the Fisher equation

1. i = r + τ

where i is the nominal or market interest rate τ is the expected rate of inflation and r is the real interestrate. Since the real value of bonds will deteriorate at the expected rate τ, the real interest rate expected to be earned on them will equal r, the implicit interest rate earned on real assets. The interest rates implicitly earned on real assets do not contain premia for expected inflation because the market value of those assetswill rise with inflation along with the earnings on them. Of course,interest is not directly earned on real assets---earningson those assets are the streams of implicit or explicit rental incomefrom their use. The implicit interest rate on those assets is the ratio of those earnings to their present value.

When the nominal interest rate earned from holding money iszero, the real interest rate expected will be -τ, the deterioration in the value of money expected to result from inflation. The sacrifice from holding money instead of cars or TV sets will thusbe equal to the real interest that could have been earned by holding those real assets, r, plus the expected annual deteriorationin the real value of money holdings, τ. This will sum to i . And the sacrifice from holding money instead of bonds will equal the real interest expected on bonds, r, plus the expected annual deterioration in the real value of money holdings---these also sum to i, the nominal return from holding bonds. The opportunity cost of holding money instead of other assets is thus equal to the nominal interest rate.

The higher the nominal interest rate, the smaller will be thedesired level of real money holdings. A decline in the nominalinterest rate will thus shift DD to the right in Figure 2.The demand for real money holdings will also be affected bychanges in transactions technology. For example, the introductionof automatic teller machines (and before them, credit cards) willhave made money holdings more accessible, reducing the amount ofreal money balances needed to effect a given volume of transactions.People would be expected to have reduced their real money holdingsas a result, shifting the DD curve to the left. Speculative shocks to desired real money holdings can also occur in response to expected future changes in nominal interest rate and the resultant capital gains or losses from holding bonds instead of money.

The cause of inflation can now be easily seen from Figures1 and 2. A rise in the price level, or fall in the value of money,can result only from an increase in the supply of money or declinein the demand for money. While the general growth of income willincrease the demand for money and improvements in the technology ofmaking transactions will reduce it, these effects will be gradualover time. They can thus account for changes in inflation rates ofonly a few percentage points. And the government can offset theseeffects by appropriate adjustments of the money supply. The causeof major inflations, of 10 percent per year or more, will inevitablybe excess expansion of the money supply on account of the policiesof the government---in particular, the monetary finance of governmentexpenditures.

We conclude this Topic by introducing the concept of velocityof circulation. The income velocity of money is defined as theratio of nominal income to nominal money holdings or, equivalently,the ratio of real income to real money holdings:

2. V = P Y / M = Y / (M/P)

where V is income velocity and Y is real income. An income velocity (ratio of income to money) of 4, for example, means thateach dollar has to be spent (or circulate) 4 times to transact thelevel of income. A higher demand for money balances (or desiredratio of money to income) implies a lower income velocity. Whenwe multiply both sides of Equation 2 by M we obtain

3. M V = P Y

which is called the equation of exchange. The equation of exchange states that the nominal money stocktimes the income-velocity at which it circulates equals the flowof nominal income. Using some elementary calculus we can take therelative changes of both sides of Equation 3 to obtain

4. ΔM / M + ΔV / V = Δ P / P + ΔY /Y

which can be rearranged to bring ΔP / P to the left sideto obtain

5. ΔP / P = ΔM / M + Δ V / V − ΔY / Y

To maintain the inflation rate, ΔP / P, equal to zerothe central bank must increase the money supply at the rate

6. ΔM / M = ΔY / Y − Δ V / V

Define Real Money Supply Curve

If real income is growing at 3 percent per year and incomevelocity is, say, falling at 1 percent per year, the central bankcan maintain a zero rate of inflation by increasing the nominalmoney supply at 3 percent plus 1 percent, or4 percent per year. Positive inflation thus results when thegovernment increases the money supply at a rate in excess of thegrowth rate of income minus the rate of growth of income velocityor plus the rate of growth of the demand for money.

It is now time for a test on this Topic. As always, think up your ownanswers before looking at the ones provided.

Question 1
Question 2
Question 3

Choose Another Topic in the Lesson

Please enable JavaScript if it is disabled in your browser or access the information through the links provided below.
Most Frequently Asked QuestionsAbout the FedBanking and the Financial SystemMoney, Interest Rates, and Monetary PolicyCredit, Loans, and MortgagesCurrency and CoinEconomy, Jobs, and PricesFederal Open Market CommitteeRegulationsAll Questions
  • Ask Us

What is the money supply? Is it important?

The money supply is the total amount of money—cash, coins, and balances in bank accounts—in circulation.

Define Real Money Supply Macroeconomics

The money supply is commonly defined to be a group of safe assets that households and businesses can use to make payments or to hold as short-term investments. For example, U.S. currency and balances held in checking accounts and savings accounts are included in many measures of the money supply.

There are several standard measures of the money supply, including the monetary base, M1, and M2.

  • The monetary base: the sum of currency in circulation and reserve balances (deposits held by banks and other depository institutions in their accounts at the Federal Reserve).
  • M1: the sum of currency held by the public and transaction deposits at depository institutions (which are financial institutions that obtain their funds mainly through deposits from the public, such as commercial banks, savings and loan associations, savings banks, and credit unions).
  • M2: M1 plus savings deposits, small-denomination time deposits (those issued in amounts of less than $100,000), and retail money market mutual fund shares. Data on monetary aggregates are reported in the Federal Reserve's H.3 statistical release ('Aggregate Reserves of Depository Institutions and the Monetary Base') and H.6 statistical release ('Money Stock Measures').

Real Money Supply M P

Over some periods, measures of the money supply have exhibited fairly close relationships with important economic variables such as nominal gross domestic product (GDP) and the price level. Based partly on these relationships, some economists—Milton Friedman being the most famous example—have argued that the money supply provides important information about the near-term course for the economy and determines the level of prices and inflation in the long run. Central banks, including the Federal Reserve, have at times used measures of the money supply as an important guide in the conduct of monetary policy.

Money Supply Economics

Over recent decades, however, the relationships between various measures of the money supply and variables such as GDP growth and inflation in the United States have been quite unstable. As a result, the importance of the money supply as a guide for the conduct of monetary policy in the United States has diminished over time. The Federal Open Market Committee, the monetary policymaking body of the Federal Reserve System, still regularly reviews money supply data in conducting monetary policy, but money supply figures are just part of a wide array of financial and economic data that policymakers review.

Related Information

Related Questions

Define Real Money Supply Calculator

Back to Top