Increasing Money Supply

January 15th, 2009 | economics, money -

Readers Question: I’d like to ask you about routine ways (apart from so called “printing new money”) by which the total volume of money in economy grows.

Governments or central banks “print new money” apparently only rarely, but given the fact of almost persistent inflation throughout decades, the total volume of money in the economy must grow persistently and significantly anyway.

If a central bank lends money, does it (in normal circumstances) always only turn the central bank’s cash into central bank’s (loan) debtors? Is it really absolutely unusual that by giving a new loan a central bank at the same time also increases its assets and capital (i.e. makes a capital injection into its cash, increasing that way its cash rather than using only its old cash to give a new loan)?

Also, when we are talking about “printing new money”, does it only mean issuing new money for the government expenses rather than only for the central bank’s loans, new money being issued in that or other way anyway?

The money supply measures the stock of money in the economy.

A narrow definition of money (M0) includes the stock of notes / coins and operational deposits at Bank of England
A broad definition of money (M4) is notes and coins + deposits in bank accounts+ other liquid assets.

There are 3 ways to increase the money supply

Print more notes – usually by Central Banks
Increase lending of money by Banks – If banks hold a small % of bank deposits as cash, they can lend out more cash and this increases the money Supply
Central Bank buying government securities. i.e. Central Bank pay people in return for bonds. If the Central Bank buy Government securities (or corporate bonds) People who were holding the bonds have more money to spend.

In recent decades the money supply has been increasing because:

Reduction in reserve ratio by banks
Creation of new types of liquid assets which
Increased velocity of circulation. – The number of times cash changes hands.

Link Between Money Supply and Inflation MV=PY

In theory an increase in the Money supply causes inflation (if money supply increases faster than real GDP)

However, in practise the link between money supply and inflation is weak.

One reason is that the velocity of circulation (number of times cash changes hands) is volatile – it tends to follow the business cycle. For example, in 2008, a recession in the US caused the velocity of circulation to fall and therefore money supply grew slower despite increases in the monetary base.