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 the economy grows.
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.
Ways to increase the money supply
- Print more money – usually, this is done by the Central Bank, though in some countries governments can dictate the money supply. For example in Zimbabwe 2000s – the government printed more money to pay wages.
- Reducing interest rates. Lower interest rates reduce the cost of borrowing. This makes investment relatively more profitable, and so encourages economic activity. Consumers will also see cheaper mortgage payments leading to higher disposable income. Read more – effect of cutting interest rates
- Quantitative easing The Central Bank can also electronically create money. Under a policy of quantitative easing, they decide to increase their bank reserves ‘effectively create money out of thin air’. The created money can be used to buy assets; the idea is to increase cash reserves of banks.
- Reduce the reserve ratio for lending. The reserve ratio is the percentage of deposits that bank keeps in cash reserves. If the reserve ratio is reduced, then the bank will lend more and due to the money multiplier, we will see a rise in bank lending. Central Banks can set a minimum reserve ratio. Reducing this ratio
- Increase confidence in the banking system. If banks have confidence in the financial system, then they will be more willing to lend. In the credit crisis, it was necessary for the government to guarantee bank deposits and nationalise struggling banks
- Central Bank buying government securities. The Central Bank pays investors holding bonds. If the Central Bank buy Government securities (or corporate bonds) people who were holding the bonds have more money to spend. Banks see illiquid assets become liquid. Therefore, in certain circumstances, this can lead to an increase in the money supply. However, it depends on whether the bond purchases are sterilised or ‘unsterilised’. Unsterilised means they create money to buy bonds.
- Expansionary fiscal policy. In a recession, there is often a ‘paradox of thrift’ business and consumers want to increase savings – and this leads to a fall in spending and investment. If the government borrows from the private sector and spends on public work investment schemes then this will start a multiplier effect where households gain wages to spend and encourage private sector investment.
In recent decades the money supply has been increasing because:
- Reduction in reserve ratio by banks – seeking greater profitability
- Creation of new types of liquid assets which make it easier for banks to lend
- 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)
- In practice, the link between money supply and inflation can be 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.
In 2005-07, money supply was growing at between 10 and 15% a year. After the credit crunch and global recession, money supply growth became negative. The fall in the money supply was due to a decline in bank lending as they sought to improve their position.
Impact of increasing money supply on interest rates
Usually, an increase in the money supply will lead to a fall in interest rates. Lower interest rates will also increase investment, economic activity and inflation.
However, in a liquidity trap, an increase in the money supply may have no effect on reducing interest rates.