Money Supply

Additionally, as pointed out by the monetarist economist Anna Schwartz, there is a relationship between the components of these measures of money supply and how they are primarily used as a medium of exchange or a store of value. The components of the most liquid measures of the money supply, M0 and M1, all act as a medium of exchange in the economy, while the added components of M2 are used primarily as a store of value. Thus, the general idea is that there is a positive relationship between the medium of exchange property and liquidity.

The role of the money supply in the way that many economists think about inflation has evolved in the past decade as a result of changes in how the Fed conducts monetary policy. Before 2008, an increase in the monetary base was generally agreed to stimulate the economy in the short run and increase the price level in the long run. Today, monetary policy remains central in the determination of inflation, but the role of the monetary base is much reduced.

What changed is that the Fed received authority from Congress to pay interest on reserves (IOR) to banks for the reserves they hold at the Fed. The Fed responded to the 2007-2009 recession in part by engaging in massive purchases of Treasuries and mortgage-backed securities, adding greatly to the monetary base. By adjusting the interest rate on reserves appropriately, inducing banks to maintain high levels of reserves at the Fed, the Fed avoided the situation in which this infusion into the monetary base would lead to inflationary increases in bank deposits and lending and, therefore, in the money supply.

In short, in the post-2008 world, the Fed controls inflation by controlling the interest rate on excess reserves. Thus, an increase in the monetary base no longer necessarily leads to an increase in the money supply or, therefore, to an increase in the price level. Put differently, the familiar textbook relationship between central bank money creation and inflation has become less useful for understanding inflation.

M1 and IOR might not be the best cocktail party conversation starters, but knowing about the money supply and its evolving role is important for monetary policy.