UNIT 3 Money Supply

Money supply in most countries comprises currency – banknotes and coins issued by the central bank and various kinds of deposits held by the public at commercial banks.

The definition of the money has varied. For centuries physical commodities, most commonly silver or gold, served as money. Later paper money became the main financial instrument around the world. To regulate the national economy and influence the world trade monetary authorities have the power to issue paper money without legal restrictions.

As money is used in all economic transactions, it has a great effect on economic activity. The amount of money in circulation and its velocity of circulationdetermine the average level of prices and wages. An increase in the supply of money puts more money in the hands of consumers, making them feel wealthier, thus stimulating spending. Business firms respond to growing sales by ordering more raw materialsand intensifying production. The spread of business activity increases the demand for labour. In a booming economy stock market prices rise and firms issue shares and bonds. If the money supply continues to expand, prices begin to rise, especially if output growth reaches capacity limits. Lenders insist on higher interest rates to offset an expected decline in purchasing power.

Opposite effects occur when the supply of money falls. Economic activity declines and either disinflation (reduced inflation) or deflation (falling prices) results.

The most important determinant of the money supply is the central bank. By increasing or decreasing the money supply, the central bank indirectly influences interest rates, demand, output, unemployment and prices. The central bank can reduce the reserves available to commercial banks by changing the reserve requirements. This reduces the amount of money that banks can create and makes the money tight.