Principles of Economics/Money Supply
The money system is a significant improvement over the barter (item for item) system because while the former allowed trading between anyone who cared for money, the latter could only take place between parties with nearly equivalent marginal benefits of all traded goods (or otherwise, one side would be unwilling to make the trade). Money serves several purposes:
- Medium of exchange - as an object that is generally accepted as a form of payment, thereby increasing market flexibility
- Unit of account - a means of keeping track of how much something is worth (in barter systems, it becomes difficult to see how much a traded item is being traded for in terms of worth)
- Store of value - can be held and exchanged later for goods and services, at an approximate (though slowly changing) value
Money is in two forms:
- Currency C - circulating money
- Deposits D - placed in banks and other depository institutions
- Reserves R - the fraction of deposits that banks are required to hold on to
The money supply is the amount of M1 in the economy (the effective money). The supply of money is determined by the Central Bank through 'monetary policy; the economy then has to make do with that set amount of money. Since the economy does not influence the quantity of money, money supply is considered perfectly vertical (on models).
Consequences of changing the Money Supply
- Since increasing the money supply can affect AD, then ceteris paribus (cp.) inflation in prices will result at the same time as an increase in output, as can be shown on any supply and demand diagram. A central bank must decide whether the benefits of demand-side economic growth outweigh the costs of potential demand-pull inflation.
- This resultant inflation could cause the currency to depreciate against others, as fewer goods and services can be bought for the same nominal amount of money. This means that the exchange rate is lower, increasing the price of imports and increasing the competitiveness of exports with their associated effects on the economy!
The equation MV = PY can be roughly translated as money supply times how fast it cycles through the economy (in a given time period) equals the output of the economy (in a given time period) times the price index. Both sides of the equation reflect the amount of money being used over the course of a period of time. An increase in the money supply (M) means that there will be more money being used by the economy; an increase in the velocity of money (V) means that this money goes through the economy faster (recycles into different hands faster), thereby seeming to increase the money supply. The output (Y) is the amount of goods produced in the economy over the period of time; multiply this by the price index (P) and one obtains the total price of all goods produced. This must equal the amount of money being used over that period of time; otherwise, some production would not have occurred.