Many of the actions central banks and commercial banks perform affects the money supply of an the economy they are located in. But what is the ‘money supply’? What does it mean? Is it just what its name suggests or is there more to it? These are all questions I had at one point when I was researching the subject. If you have similar questions then this page is where you want to be because I will be answering all of those questions and more. So sit back, relax and be prepared to learn more about ‘money supply’.
Money Supply: What is it and What it Means for an Economy
Whenever I think about the money supply of an economy, I instantly start thinking about supply and demand. In economics, everything seems to be based on supply and demand. Money is no different. The money supply of an economy is exactly what its name implies. It is the supply or amount of money in an economy; a money supply is the amount of money in circulation. That’s all it is. Now before you pack up and head on your way, allow me to explain what happens to an economy when there is a large amount of money in circulation and when there is a small amount of money in circulation.
But first, here’s a key question to start with: When there is a very large amount of money in an economy’s money supply, how does it affect an economy overall? First we would have to determine what ‘large’ is. What constitutes as being a large amount of money for an economy? How do we figure out whether an economy has a large money supply or not? The answer to that is one word: demand. Assessing demand for money is key for determining if there is too much money in an economy’s money supply or not. You may say to yourself, ‘There’s always demand for money. Everyone always wants money.” And I would agree; you would be right in thinking that. But you may even think that demand for money is always high because people always want money. Quite the contrary, demand for money has risen and fallen many times in the past dating back to, well, to the invention of money.
What evidence do I have to support that statement? How do you figure out what the demand for money is? Prices. The prices of goods and services would indicate to you the demand for money. Let me expound on this farther.
If there is more money than there is demand for it, then money over time will become less valuable. Why? Because more consumers have money. If more consumers have a lot of money, money becomes less valuable. As a result of money becoming less valuable, the amount of money required to buy goods and services will increase. It would require more of the less valuable money to buy the same amount goods and services. This is called inflation. You see, you can determine the demand for something by measuring how valuable that something is.
You can determine the value of ‘something’ by assessing what others would give you for that ‘something’. Now lets replace ‘something’ with ‘currency a’. If you can buy a lot of goods and services for a relatively small amount of ‘currency a’, that means ‘currency a’ is very valuable. And if ‘currency a’ is very valuable, that means there is a high demand for ‘currency a’. Are you following along? If ‘currency a’ continues to increase in value and in response to the increasing value of ‘currency a’ prices of goods and services will continue to fall over time (deflation). Then would be safe assume that there is more demand for ‘currency a’ than there is available. So we can deduct that there is a small amount of money in the money supply of an economy relative to demand.
The opposite can occur as well. If it would take more of ‘currency a’ to buy the same amount of goods and services, then that would be a sign that ‘currency a’ is becoming less valuable. If ‘currency a’ continues becoming less valuable and the prices of goods and services continue to increase rather than decrease, it would be safe to assume that there is more supply of ‘currency a’ than there is demand for it. Why? Because ‘currency a’ is becoming less a valuable over time. I hope you’re following along.
Now you should have an idea on how to determine the level of demand for money by assessing prices. Back to the original question: When there is a very large amount of money in an economy’s money supply (more supply of money than demand for it), how does it affect an economy overall? Whenever there is a large amount of money in an economy’s money supply, generally prices for goods and services would increase (remember, this is also known as inflation). As money becomes less and less valuable over time, it will take more and more money to buy the same basic goods and services.
Eventually, this will throw an economy into an inflationary spiral where no one can afford to buy basic goods and services over time. If no one can afford to buy goods and services that means no one is buying goods and services. If that occurs then producers in an economy will start producing less and less goods and services, which in turn will lower the output of an economy. Producers would also have to fire employees because if there are fewer customers buying goods and services, there will be fewer employees. Boom. You now have an economy suffering from worthless, debased money, economic contraction of output and increasing unemployment. That’s what happens when you have way too much money in an economy’s money supply. And believe it or not, the same thing would happen if the opposite were true. Let me explain.
If there is a very small amount of money in an economy’s money supply, you would basically run into the same economic problems. If money becomes more valuable over time, that means the prices for goods and services would decrease. If prices for goods and services continues to decrease, consumers would naturally stop buying for they will come to expect prices to continue to decline. Would you hurry to buy a house for $500,000 when you know that it will be $420,000 in one year? Probably not. Would you hurry to buy a car for $50,000 when you know that a newer model car would be $38,000 in a year? Of course you wouldn’t hurry. Now if many consumers did this, and not just with homes and cars but with many other goods and services, the economy as a whole would begin to stall, then contract. Next thing you know, producers would have to start laying off employees because consumers aren’t buying. The economy’s output would start contracting, unemployment would start increasing and bank leading would start to decline.
As you see, having too much money or having too little money in an economy’s money supply isn’t good for economic growth. There needs to be a balance. So how much money should there be? There should be just enough money circulating in an economy where prices for goods and services remain stable or increase very slightly over time. If prices for goods and services stay stable or increase very slightly, that means that consumers are incentivized to buy goods and services as quickly as possible, for prices for those goods may increase in the future. But if the prices for goods and services do increase, they won’t increase significantly to the point where consumers cannot afford them and the value of money doesn’t completely disappear.
You should now have an understanding of what money supply means, how to determine if there is too much money or too little in an economy’s money supply and the affects of having too much and too little money circulating in an economy.