:+:Chapter 5 The money supply and the central bank

posted on 15 Feb 2011 16:06 by marry-dodo

Chapter 5

The money supply and the central bank


The money supply and the central bank


          The Money Supply is the sum of all money in particular country. Before going into details we need to define what is money. For thousands of years the mankind has been using commodity money, most notably silver and gold. However most world countries use fiat currencies now, which don't have any intrinsic value, and are subject to the worst of all taxes – inflation. The fiat money supply includes paper bills, coins, and demand deposits. Money supply is measured in several different ways depending on what exactly is considered to be money. 

Money Aggregates

Every country has its own ways to measure money supply, but in general there are several money aggregates used throughout the world. In our example we'll use the US monetary aggregates.

M1 – M1 is the narrowest measure of money, which includes physical currency and demand deposits.
     M2 – M2 is a broader measure of money, which everything already included in M1 plus time deposits, savings deposits, non-institutional money-market funds and small CODs.
        M3 – M3 is even broader measure of money, which includes M2 plus large savings and time deposits (over $100K) and institutional money-market mutual funds.

Money Supply Control
In a fractional-reserve banking system the money supply is controlled through managing short-term interest rates. The interest rates are usually managed by the country's central bank. When the central bank increases interest rates, it becomes more expensive to borrow, and less money is created through loans, which in turn slows the growth in money supply or decreases it (the money supply shrinks when more loans funds are repaid, than borrowed). The opposite is also true – when interest rates trend down, borrowing increases, and new money created through loans are added to the economy. 


Central bank

          Central Bank is a financial institution that controls country’s monetary policy, and usually has several mandates including, but not limited to issuing national currency, maintaining the value of the currency, ensuring financial system stability, controlling credit supply, serving as a last-resort lender to other banks and acting as government’s banker. The central bank might be or might not be independent the government. In theory independent central bank, will ensure there is no political influence over the central bank’s policy; however even with the so-called "independent central banks" that is not always the case. 

         Some of the well-known central banks are the US Federal ReserveBank of EnglandBank of CanadaReserve Bank of Australia, and the European Central Bank. Some central banks are responsible for single’s country monetary policy, for example the Bank of Canada, while others manage the monetary policy of group of countries like the European Central Bank. There is no single naming convention for central bank’s naming, but usually the name is in one or close to one of the following forms – Bank of [Country], Central Bank of [Country] or National Bank of [Country]. One notable exception here is the US Federal Reserve.                                                                                                     On the surface it appears that central banks have noble goals and work for the greater good, however many people consider the real role of a central banking system to be supporting the fractional-reserve banking system, which enriches the financial elite at the expense of the common people.

Short-term Inst Rates 

         One of the most powerfultere weapons in central banks’ arsenal is the short-term interest rate setting. The short-term interest rate is the overnight interbank lending rate. Lowering the short-term interest rate in effect lowers the cost of credit, thus stimulating people and businesses to borrow in hope to expand the economy. Increasing interest rates, makes borrowing more expensive, and is usually used to control overheating economies and inflation.

Open Market Operations 
         Open market operations are purchases and/or sales of government securities in the open market. Central banks use open market operations to effectively control the money supply – the total amount of money circulating in the country’s economy. Purchasing government securities expands the money supply, while selling them actually contracts the money supply.