Money Supply

Money Supply, the amount of money freely circulating in an economy. Money includes notes and coins, and also bank deposits. It is graded according to its liquidity: very liquid assets are narrow money; money that includes less liquid assets is broad money. The broader money is, the harder it is to measure or control.

Narrow money is commonly referred to as M1 and is usually defined as holdings of notes, coins, and “sight” deposits (cheque accounts from which money can be withdrawn on demand) in the non-bank private sector. Broad money is commonly referred to as M2 and includes M1 plus time and savings deposits, and foreign currency deposits of residents.The even broader measures of M3 and M4 include other liabilities of financial institutions. However, different countries define narrow money and broad money in their own ways; for example, in Australia M2 includes certificates of deposit, and in Germany, M1 includes deposits that can be withdrawn on up to one month’s notice. In the United Kingdom, both M0 and a more narrowly defined M2 (and not M1) are used as the measures of narrow money. M0 is cash in circulation, plus the operational deposits of banks that are held by the Bank of England, the central bank. Britain’s measure of broad money, M4, includes the sterling liabilities of banks and building societies to residents.

Control of the money supply is one aspect of monetary policy, which the monetary authorities may seek to carry out by targeting particular measures or an aggregate measure and using the tools available to them to keep the money supply on target. The options monetary authorities have to control or influence the money supply include: adjusting the level of reserves that commercial banks must maintain relative to the loans they make; buying or selling government bonds in the open market; influencing interest rates; and imposing credit controls, such as total personal credit or total bank lending.

How much growth in the money supply matters is disputed by economists. According to the quantity theory of money, which lies at the heart of monetarism, changes in the money supply ultimately affect only prices, and, therefore, an increase in the money supply will, in the longer term at least, lead to higher prices not higher output. Advocates of Keynesianism, on the other hand, take a different view.

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Money

I INTRODUCTION

Money, any medium of exchange that is widely accepted in payment for goods and services and in settlement of debts. Money also serves as a standard of value for measuring the relative economic worth of different goods and services. The number of units of money required to buy a commodity is the price of the commodity. The monetary unit chosen as a measure of value need not, however, be used widely, or even at all, as a medium of exchange. During the colonial period in North America, for example, Spanish currency was an important medium of exchange, while the British pound sterling served as the standard of value.

II MONEY AND THE ECONOMY

The functions of money as a medium of exchange and a measure of value greatly facilitate the exchange of goods and services and the specialization of production. Without the use of money, the trade would be reduced to barter or the direct exchange of one commodity for another; this was the means used by primitive peoples, and barter is still practised in some parts of the world. In a barter economy, a person having something to trade must find another who wants it and has something acceptable to offer in exchange. In a money economy, the owner of a commodity may sell it for money, which is acceptable in payment for goods, thus avoiding the time and effort that would be required to find someone who could make an acceptable trade. Money may thus be regarded as a keystone of modern economic life.

III TYPES OF MONEY

The most important types of money are commodity money, credit money, and fiat money. The value of commodity money is about equal to the value of the material contained in it. The principal materials used for this type of money have been gold, silver, and copper. In ancient time, various articles made of these metals, as well as of iron and bronze, were used as money, while among primitive peoples such commodities as shells, beads, elephant tusks, furs, skins, slaves, and livestock served as media of exchange. Credit money is paper backed by promises by the issuer, whether a government or a bank, to pay an equivalent value in the standard monetary metal. Paper money that is not redeemable in any other type of money and the value of which is fixed merely by government edict is known as fiat money. Most minor coins in circulation are also a form of fiat money because the value of the material of which they are made is usually less than their value as money.

Both the fiat and credit forms of money are generally made acceptable through a government decree that all creditors must take the money in settlement of debts; the money is then referred to as legal tender. If the supply of paper money is not excessive in relation to the needs of trade and industry and the people feel confident that this situation will continue, the currency is likely to be generally acceptable and to be relatively stable in value. If, however, such currency is issued in excessively large volume in order to finance government needs, confidence is destroyed and it rapidly loses value. Such depreciation of the currency is often followed by formal devaluation, or reduction of the official value of the currency, by governmental decree.

IV MONETARY STANDARDS

The basic money of a country (or group of countries, as in the case of the European Union and the Euro), into which other forms of money may be converted and which determines the value of other kinds of money, is called the money of redemption or standard money. The monetary standard of a nation refers to the type of standard money used in the monetary system. Modern standards have been either commodity standards, in which either gold or silver has been chiefly used as standard money, or fiat standards, consisting of inconvertible currency paper units. The principal types of the gold standard are the gold-coin standard; the gold-bullion standard consisting of a specified quantity of gold; and the gold-exchange standard, under which the currency is convertible into the currency of some other country on the gold standard. The gold-bullion standard was used in Great Britain from 1925 to 1931, while a number of Latin American countries have used the dollar exchange standard. Silver standards have been used in modern times chiefly in the Orient. Also, a bimetallic standard, the system of bimetallism, has been used in some countries, under which either gold or silver coins were the standard currency. Such systems were rarely successful, largely because of Gresham’s law, which describes the tendency for cheaper money to drive more valuable money out of circulation.

Most monetary systems of the world at the present time are fiat systems; they do not allow free convertibility of the currency into a metallic standard, and money is given value by government fiat or edict rather than by its nominal gold or silver content. Modern systems are also described as managed currencies because the value of the currency units depends on to a considerable extent on government management and economic policies. It is a recurrent problem whether the value of the inconvertible-credit currency can be maintained at a fairly stable level for extended periods of time.

V ECONOMIC IMPORTANCE

Credit, or the use of a promise to pay in the future, is an invaluable supplement to money today. Most business transactions use credit instruments rather than currency. Bank deposits are commonly included in the monetary structure of a country; the term money supply denotes currency in circulation plus bank deposits.

The real value of money is determined by its purchasing power, which in turn depends on the level of commodity prices. According to the quantity theory of money, prices are determined largely or entirely by the volume of money outstanding. Experience has shown, however, that equally important in determining the price level are the speed of turnover of money and the volume of production of goods and services. The volume and speed of turnover of bank deposits are also significant.

VI HISTORY OF MONEY

Miniature bronze knives, axes, and other tools, used in place of the real tools which served as items of exchange, were circulating in China as early as 1100 bc. Coins, made of electrum, first appeared around the 6th-century bc in the district of Lydia, in Asia Minor, at that time an important industrial and trading country. Such money was genuine commodity money, with a value determined by its metallic content. Coins rapidly proliferated throughout the world’s more developed economies. Monarchs, aristocrats, cities, and institutions began making money stamped with their identifying mark as a certificate of authenticity testifying to the coin’s metallic value.

Some early coins had a very stable composition, such as the drachma issued by Athens from the 6th-century bc which kept a fairly constant content of 65-67 grains of fine silver, or the round copper Chinese Qian (cash) introduced in the 4th century, which remained a standard coin for 2,000 years. However, coins were always being clipped or shaven by holders for their precious metal, and issuing authorities were prone to debasing the coinage, securing a short-term profit by reducing the precious metal content. Low-denomination coins of bronze or copper were effectively fiat money, with a value depending mainly on the number of gold or silver coins they could be exchanged for. Gold or silver coins in particular often circulated outside their country of the issue because of their intrinsic value: thus the Spanish silver peso became a current coin in China from the 16th century.

Once established, coins created a monetary system whose characteristics remains essentially constant for millennia, one of the few enduring changes being the introduction of milled edges for European coins in the 17th century to deter clipping. Paper currency was first introduced in China around the 9th century, as redeemable cash certificates issued for the Tang dynasty government by private bankers. Backed by the pervasive authority of the Chinese state, such money could retain its value across the empire, obviating the need for transport of weighty silver. Made a government monopoly under the Song dynasty, paper currency persisted through Chinese history, despite upsets caused by political change and issuing of paper not backed by silver or other reserves. The problem of paper debasement kept silver as the Chinese standard for big transactions thereafter. Paper money first arose in the West in the 16th century, as promissory notes issued by banks against money deposits held in the bank. Such notes of exchange proliferated: French colonial authorities in Canada used playing cards signed by the governor as a promise of payment from 1685 since the shipment of money from France was slow.

Paper money became increasingly common from the 18th century but remained credit money, issued against deposits in gold or silver. Fiat money, when it arose, was usually an emergency measure in wartime, like the American greenback. Private banks were increasingly supplanted by central banks as the issuing authorities for paper currency. By the late 19th century, falls in the value of gold led to an international gold standard, in which all currencies were interchangeable with gold, and money value (rather than prices) fixed by the currency’s accepted parity with gold. Most governments suspended their currencies’ convertibility in World War I and attempts to reintroduce the international gold standard foundered after the Depression. Great Britain left the gold standard in 1931, and the transformation of the world’s currencies into fiat money with values fixed wholly by market demand was completed by the severance of the United States dollar’s link to gold in 1971.

VII STANDARD AND TOKEN COINS

Metallic coins may be either standard coins or token coins. Standard coins are made of standard monetary metal and are worth as much as or slightly more than the metal they contain. Token coins are those that have far greater nominal than metallic or intrinsic value; in this respect, they are analogous to paper money. These coins usually consist of alloys of precious and base metals. The mints of most countries made both standard and token coins during the 19th century, but with the widespread abandonment of the gold standard between World Wars I and II, standard coins have been withdrawn from circulation in almost every part of the world.

VIII MINTING AND PRINTING

Modern minting involves several distinct processes. The particular metal is first melted and cast into bars, which are then rolled into strips of uniform thickness and quality. These strips are run through machines that punch out circular metal discs, called planchets. The planchets are then checked for accuracy of weight. If they are too heavy, they are filed down at the edges, if too light, they are remelted and recast. The rims of acceptable planchets are rolled so as to project beyond the surface of the coins and protect them from wear. The planchets are then cleaned and, at the last stage in the process, struck by dies with the impression of the finished coin. Many types of coins also have their edges milled, that is, grooved, to expose later clipping or filing, in the case of standard coins, and to aid in their handling. Shapes and sizes are often calculated to assist the blind in distinguishing coins.

Banknotes, often printed to contract by private companies, are normally made from special high-quality paper, with watermarks, metallic strips, and other features to deter forgery. Highly sophisticated printing techniques are used, also to deter forgery, and banknote designs often feature elements intended to be particularly hard to copy. Fronts and backs of notes are printed separately, and serial numbers added later, with repeat numbers with stars appended used for those notes damaged in the manufacturing process.

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