Macroeconomics concepts and applications

¶ … measuring the money supply and discusses their respective importance. Measurements of the money supply are used to monitor money supply growth because of its relationship to real economic activity and to price levels. In the past the Federal Reserve attempted to meet macroeconomic goals of high employment, economic growth, and price stability by managing the size of the money supply. However, in more recent decades, the relationship between the performance of the U.S. economy and the money supply has grown less pronounced, resulting in less dependence on the money supply as a tool of monetary policy (Federal Reserve Bank, 2008).

The different measures of the money supply correspond to different degrees of liquidity. M0, used in the UK and also known as narrow money, is the most liquid measure of the money supply, and includes cash in circulation, including all coins and printed money (WebFinance, 2011). The next narrowest measure is M1, which also measures only liquid forms of money: currency in the hands of public, traveler's checks, demand deposits (bank accounts), and other deposits against which checks can be written. M2 includes M1 as well as savings accounts, time deposits less than $100,000, and balances in retail money market funds. Until March 2006, the Federal Reserve also published data on M3, which included M2 along with all large time deposits, institutional money-market funds, short-term repurchase agreements and other larger liquid assets. Because the information that M3 measurements provided did not appear to be substantially more informative than M2, the Federal Reserve Board of Governors discontinued its publication (Federal Reserve Bank, 2008).

Similarly, M2 is no longer considered to provide the significant information about economic activity that it once did. In July 1993, Fed Chairman Alan Greenspan commented that "The historical relationship between money and income, and between money and the price level have largely broken down, depriving the aggregates of much of their usefulness as guides to policy. At least for the time being, M2 has been downgraded as a reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place" (Federal Reserve Bank, 2008). Nonetheless, M2 when adjusted for changes in the price level, is still a component of the Index of Leading Indicators, and some market analysts use it to forecast economic recessions and recoveries (Federal Reserve Bank, 2008).

Measuring the money supply is not without controversy. The policy of manipulating the money supply in order to control inflation is based on the idea that the more money there is in circulation, the more money there is chasing fewer goods, resulting in higher prices and vice versa. Governments have the ability to control the amount of money in circulation. They do this by stimulating demand by printing more money or by reducing demand by removing money. The process of achieving specific targets is difficult and governments frequently miss their goals, resulting in recessions and booms, all of which make up the economic cycle (Benson, 2007).