What is Money Supply, Inflation?

In ‘What is Money Supply?’ we look at different types of money, where it comes from and what it means for the economy.

Money supply

Money supply (sometimes called money stock) is the total amount of money held by the non-bank public. When classifying money we generally separate categories as follows (note different countries do this differently):

• M0. All physical currency (notes & coin), as well as central bank accounts that can be exchanged for physical currency (see what is money)
• M1. M0 plus money in checking or current
• M2. M1 plus most savings accounts, money market accounts, and small term deposits (certificates of deposit).
• M3. M2 plus all other term deposits (CDs), institutional money-market funds, repurchase agreements and other large liquid assets.

The practice of fractional-reserve banking leads to large variations in money supply.

Fractional-reserve banking

Most nations use fractional-reserve banking. When banks give out loans in fractional-reserve banking a new type of non-M0 money is created (the M1-M3 components). Large differences in the different types of money exist based on bank margin requirements. The above image shows money supply for the US (www.dollardaze.org). FRB is covered in more details in a dedicated post.

Money and inflation

The money supply equation (MV=PQ) provides a useful framework for considering the link between money supply and inflation. Here:

• M is the total supply (M0 to M3) of a nation.
  
• V is the velocity of money measured as the number of times per year each dollar is spent.
  
• P is the average price of all goods and services sold during the year.
  
• Q is the quantity of all goods and services sold during the year.
  

We simply here that if money (M) is expanded through excessive fiat money printing, then the average prices of goods and services (P) will increase. Provided money velocity and the quantity of goods and services remains constant. The increases in prices (P) will be called inflationary and a nations reserve bank will look to target that figure to the 1-3% range depending on the country.

So what is inflation?

A simple definition is that it is 'rising prices'. But that is just the symptom. What is the cause of inflation? Inflation is believed to be caused by excess money supply (fiat money printing). This was famously acknowledged by Milton Friedman with 'inflation is always and everywhere a monetary phenomenon'.

It is also important to understand that inflation measures such as the consumer price index (CPI) are an overall economic indicator. Like all averages, CPI is made up of rising and falling components. Lets look at different components:

• Rising: Food, fuel, healthcare
• Steady: Housing costs*
  
• Falling: Consumer electronics, automobiles, clothing

How you perceive inflation depends on where you live and the type of purchases you make. Let's consider three different countries:

• Indonesia: majority of purchases are food/fuel related. Indonesian's are experiencing very high inflation:
• USA: mix of food/fuel/housing expenses. Food/fuel are rising, however costs of housing are falling (July 2008). If you are buying a house then you stand to benefit from a large price decline (deflation) in housing saving you potentially tens or hundreds of thousands. If you already have a house, you are seeing only rising prices for food/fuel which is inflationary.
• Australia: mix of food/fuel/housing expenses. Food/fuel are rising, but with its booming economy, rising interest rates (not falling like in the US) is making housing and rents more expensive! Inflation in Australia is over 4% and the populace knows it.

In 'What is fractional reserve banking' and 'How to benefit from inflation' we look in more detail at these issues.

Curious readers can find out more about money supply