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What makes up the total money supply?
Besides currency in circulation does the total amount of money include gold held in private hands, gold held in public hands, the value of stocks and bonds, the value of fine art and other collectibles, money due on mortgages, the value of homes, the money owed on credit cards? Where is the line drawn and why?
Liquidity seems to be an important factor in differentiating “money” from other assets. However I once “bought” a house simply by “selling” another house to the owner, so obviously a fixed asset of rather uncertain value which is not very liquid can function as money. Given an active stable stock market it would seem that stocks are pretty liquid and of relatively certain value, so why are they not considered part of the money supply?
Nice question.
First of all, let’s see the measure of money, as used by Central Banks
M0 is physical currency. A measure of the money supply which combines any liquid or cash assets held within a central bank and the amount of physical currency circulating in the economy. M0 (M-zero) is the most liquid measure of the money supply. It only includes cash or assets that could quickly be converted into currency. This measure is known as narrow money because it is the smallest measure of the money supply.
M1 consists of M0 plus (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler’s checks of nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts, and demand deposits at thrift institutions.
M2 consists of M1 plus (1) savings deposits (including money market deposit accounts); (2) small-denomination time deposits (time deposits in amounts of less than $100,000), less individual retirement account (IRA) and Keogh balances at depository institutions; and (3) balances in retail money market mutual funds, less IRA and Keogh balances at money market mutual funds.
M3 consists of M2 plus all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets. It is the broadest measure of money.
In March 2006, the FED’s Board of Governors ceased publishing the M3 monetary aggregate.
As we can see, the main difference of these 4 types of money is the time needed to be converted into currency (to be liquid and be in circulation).
Now, in order to buy gold or to buy stocks or bonds or a house or anything at all, I need money. The amount of money I need in order to buy this house, will be out of my bank and will get to the seller’s bank. Thus, if we were counting the value of home as money, then we would have a double counting problem. The same for bonds, gold, paintings, stocks, or anything.
The line is that, the amount of money is given from the type of money the FED refers to. So, let’s say that M2 is 200 trillion. With that 200 trillion we can buy products valued 200 trillion (you cannot buy something if you don’t have the money). So, we are not counting the value of the products purchased (this will be added to GDP as Consumption), but the money that are available.
On the other hand, let’s say that I am selling my house. The money I receive, will be added to my bank’s account, but will be excluded from the buyer’s bank account, so the amount of money in the banking system will be the same.
Why is so important to know how much money are in circulation? Because the money available must almost equals the amount of product the economy produce, as well as the total income of the economy. Otherwise, we will be out of equilibrium and the economy might have surplus or deficit of money, we might have inflation, etc. By combining product, income, money supply and interest rates, we can achieve the equilibrium and the target that every time FED sets. (IS-LM model, etc).
I hope this helps