Money Supply

Central banks control the monetary base directly, but the aggregates candidates are tested on are created largely by commercial banks. When a bank extends a loan it simultaneously credits the borrower's deposit account, and that deposit is itself part of the money stock. The constraint on this process is the fraction of deposits banks must or choose to hold as reserves: in the textbook version, the maximum expansion of deposits equals new reserves divided by the reserve requirement, so a ten percent requirement implies a multiplier of ten.

In practice the multiplier is behavioural rather than mechanical. It shrinks when banks hold reserves voluntarily above the requirement, when the public prefers currency to deposits, and when creditworthy borrowers are scarce. This is why the ratio of broad money to base money is not a constant and why observed money growth can diverge sharply from central bank balance sheet growth.

Definitions are national conventions, not universal constants. In the United States M1 covers currency, demand deposits and other checkable balances, while M2 adds savings deposits, small-denomination time deposits and retail money market funds. The euro area publishes M1, M2 and M3, with M3 including repurchase agreements, money market fund shares and short-maturity debt securities. The United Kingdom reports M4, a broad measure of private sector holdings of sterling money. Comparing a figure across countries without checking the underlying components invites error.

Aggregates also drift as financial products evolve. Sweep accounts, money market funds and instant-access savings blurred the line between transaction and savings balances, which is why definitions have been revised repeatedly and why the narrowest measures have lost much of their former analytical usefulness.

The link between money and prices runs through the equation of exchange: the money stock multiplied by the velocity of circulation equals the price level multiplied by real output. Restated in growth rates, money growth plus velocity growth equals inflation plus real growth. The monetarist conclusion that sustained money growth in excess of real output growth produces inflation follows only if velocity is stable and real output is supply-determined over the relevant horizon.

Velocity is not stable in the short run. It fell markedly in the post-2008 period as precautionary deposit holdings rose, muting the inflationary effect of rapid base expansion. Candidates should treat the relationship as a long-run tendency and be prepared to explain, using velocity and the willingness of banks to lend, why a given episode of money growth did or did not translate into higher prices.

Three competencies recur. First, ordering and identifying aggregates by liquidity, and stating which instruments sit inside narrow versus broad money. Second, computing a deposit expansion or a multiplier from a reserve ratio, and explaining why the realised figure falls short of the theoretical maximum when excess reserves or currency leakage are present. Third, connecting money supply to the monetary policy transmission mechanism: open market purchases add reserves, which lower short-term rates, which affect credit growth, asset prices, the exchange rate and eventually aggregate demand.

In interpretation questions, be able to distinguish an expansion of the central bank's balance sheet from an expansion of the money held by households and firms, and to identify which of the two is relevant for spending and inflation.