In macroeconomic terms, supply of money is the quantity of currency and money held in bank accounts and the non-bank public purchasing goods, services and securities. The price of money is the rate of interest payable for it.
The market forces of demand and supply work towards establishing an equilibrium price while the quantity of interest rate and the free market interest rate balance the demand for money. Supply of money encompasses in its purview banknotes, coins and bookkeeping credits. All paper banknotes in circulation contributes to the increase in the electronic and credit-based money supply.
MO is the M1 money supply. The relation between M1 and MO is the ratio of cash and coins held by people with them, in banks and ATM to the total balances in their financial accounts.
There are three monetary aggregates: M1, M2 and M3. M1 is the transaction deposits of banks and cash in circulation, M2 adds small time deposits in banks, savings accounts and retail money market funds. M3 adds long time deposits, Eurodollars, repurchase agreements and institutional money market funds.
The equation of exchange in the quantity theory of money is MV=PT. This relates the money supply, M, and the velocity of money, V, to the average price level, P, and the total number of transactions, T, in a given time period. The formula implies that the average price level increases with the quantity of money.
Money supply is intrinsically connected with inflation. The monetary exchange equation says: velocity X money supply = Real GDP X GDP deflator. If money supply grows faster than real GDP growth, then inflation is the outcome.
The central banks of countries can increase the money supply by doing open market operations. Using this tool, the central banks purchases government securities in the open market thus increasing funds for private banks so that they can offer more loans. The central bank creates new bank reserves thus enabling the banks to lend more money. The money that is not required to be held as reserves are lent out as loans. This increases the money supply in the economy.
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Last Updated on : 26th June 2013