Money Supply (M2)

Updates

Current Status and Perspectives

January 2007
 
Total Money Supply M2, January 2007:
$7.08 trillion
Annualized Growth Rate for M2, January 2007 (relative to January 2006):
5.47%
Review the latest Money Supply (M2) data (Available at Economagic)

The following perspective is excerpted from one in a series of working papers published by the Research Division of the Federal Reserve Bank of St. Louis. In it Fed Economist Richard G. Anderson looks at the “Monetary Base” and its impact on inflation and economic growth. Most contemporary economists agree that manipulation of interest rates is more closely correlated with inflation rates than the quantity of currency in circulation:

“In all current economies, growth of the monetary base is an endogenous variable, that is, a variable determined simultaneously with other variables such as employment, output, prices, and market interest rates. In modern times, only the Swiss National Bank has included among its monetary policy objectives a growth rate for the monetary base, although the Bank of England maintained a monitoring range during one interval (Rich, 1997). Most of the world’s central banks conduct monetary policy by setting and manipulating the level of a short-term interest rate. In the United States, the Federal Open Market Committee implements policy by choosing a target level for the overnight federal funds rate (the interest rate charged by banks to each other for overnight loans of deposits at the Federal Reserve). The federal funds rate is maintained close to the target rate each day by increasing or decreasing the supply of base money.

Many empirical studies have examined linkages among growth of the monetary base, growth of broader monetary aggregates, and an economy’s inflation rate. Over long periods of time, there is a clear positive relationship: absent significant structural or regulatory changes, prolonged inflation (and, especially hyperinflation) cannot continue without increases in the monetary base. In most historical cases, excessive growth of the monetary base has reflected lack of fiscal discipline, not failure of monetary policy (Fisher, Sahay,and Vegh, 2002). Sharp reductions in inflation such as occurred in the United States during 1979-1980 typically are accompanied by, and likely require, sharp reductions in the monetary base. There is substantive disagreement regarding short-run relationships, however. While some studies assert having found direct linkages between growth of the inflation-adjusted monetary base and inflation-adjusted economic activity, other studies have found no reliable shorter-run connections. In 1988, Carnegie-Mellon University economist Bennet McCallum proposed a monetary policy rule in which the level of the federal funds rate target would be adjusted in response to growth of the monetary base. After initial widespread attention, the rule’s impact on monetary policy has diminished in recent years.”

http://research.stlouisfed.org/wp/2006/2006-049.pdf


The following perspective is excerpted from an article titled “M2 and ‘Reigniting Inflation’” written by Economist William T. Gavin in the Federal Reserve Bank of St. Louis’ publication Monetary Trends. It was published in June 2005, and examines the correlation between economic growth rates and the growth rate of M2 money supply:

“On April 7, 2005, the Wall Street Journal (WSJ) published a letter from Milton Friedman in response to a March 21, 2005, editorial that criticized the Federal Reserve’s monetary policy as being too easy for too long. Friedman defended the Federal Reserve’s actions, chastising the WSJ editor for failing to notice that M2 growth had been slowing during the period in which they claimed that the Fed was reigniting inflation. Friedman wrote, “On the contrary, since 2000, the rate of growth in the quantity of money has been trending downward and in the past year has consistently been in the range of 4% to 6%, just about the rate required for a rapidly growing non-inflationary economy.” More than any other single economist, Milton Friedman gets credit for teaching the world that central banks are responsible for inflation through their control over the money supply. This letter is not significant so much because of what it said, but because of who said it. The letter marked 70 years of publications by the prolific Professor Friedman. His first article, “Professor Pigou’s Method for Measuring Elasticities of Demand from Budgetary Data,” was published in the Quarterly Journal of Economics in November 1935. What about the message? Should slowing M2 growth give us comfort about the future of price stability? As Friedman notes, M2 growth in the range of 4 to 6 percent is consistent with healthy economic growth. Over the past 15 years, M2 has grown at an average annual rate of 4.8 percent while nominal GDP has advanced at a 5.0 percent rate.

“The short-run correlation between M2 growth and nominal GDP growth depends importantly on the nature of monetary policy and money demand. If variation in M2 is driven mainly by destabilizing monetary policy (as in the 1970s, or in the case of a hyperinflation), then we expect to see a close correlation between M2 and GDP growth. If we are in an era of relative price stability, then we expect to see the effects of shifts in money demand. We should not be surprised to see M2 and GDP growing in different directions much of the time.

“The recent moderation in M2 growth is confirmation that we continue to live in a regime of relative price stability. There is no reason to think that inflation will become a major problem for the U.S. economy unless one believes that there is going to be a major regime change in Federal Reserve policymaking.”

http://research.stlouisfed.org/publications/mt/20050601/cover.pdf


The following is excerpted from a February 22, 2006 publication by the Federal Reserve Bank of Dallas titled The Fed Today. It gives a short overview of how the Federal Reserve conducts monetary policy:


“The Fed’s foundation rests upon developing and implementing a sound monetary policy whose primary focus is price stability.

“The Federal Open Market Committee (FOMC) is the group that establishes monetary policy. The committee comprises the seven governors and the 12 Reserve Bank presidents. The Fed chairman, who reports regularly to Congress, heads the committee. Five of the 12 Reserve Bank presidents have voting authority. The president of the New York Fed is a permanent voting member and serves as the FOMC’s vice chairman. The other four votes rotate every year among the other 11 presidents.

“The committee makes decisions that affect the amount of available money and credit. For example, if the FOMC sees signs of inflationary pressures that may affect price stability, the committee may move to slow the growth of the money supply.

“As the money supply grows, so does the demand for goods and services. When more money is available, people tend to spend more. However, when the production of goods and services can’t keep up with the growth in demand, prices usually begin to rise, that is, inflation occurs.

“If there is an indication that inflation is threatening purchasing power, the Fed may need to slow the growth of the money supply. It does this by using three tools the discount rate, the reserve requirement and, most important, open market operations.

“Conversely, if the money supply and the demand for goods decrease, people buy less; prices could fall and businesses would produce fewer goods. In this case, we could have an economic slowdown, or worse, a recession.”

http://www.dallasfed.org/educate/pubs/fedtoday.html



The following passage is from a staff report issued by the Federal Reserve Bank of New York titled "What Was Behind The M2 Breakdown?" It was written by Cara S. Lown, Stavros Peristiani, and Kenneth J. Robinson. In it they discuss the usefulness of M2 as an indicator of the rate of economic growth:

"There has been a long-running debate over the usefulness of monetary aggregates as intermediate targets or information variables in the conduct of monetary policy. This issue has remained timely. The European Central Bank, for example, is reviewing whether to target a monetary aggregate or inflation in its implementation of monetary policy (Svensson, 1999). In the U.S., most recently Feldstein and Stock (1994) argued that the Federal Reserve should use the M2 monetary aggregate as an intermediate target. On the other hand, there has been a fair amount of work suggesting that M2 is not reliable as either a target or an indicator of monetary policy. Friedman and Kuttner (1992) argued that by the early 1990s the relationship between M2 and GDP had weakened, and Estrella and Mishkin’s (1998) work provided further support for this finding. In this paper, we show that depository institutions’ capital difficulties during the late 1980s and early 1990s can account for a substantial part of the deterioration in the link between M2 and GDP. With these problems now behind us, the link between M2 and economic growth has strengthened. An implication of our findings is that it may be premature to abandon M2 as an indicator of aggregate real activity. In particular, in the absence of financial sector difficulties, a monetary aggregate such as M2 could possibly provide useful information about the future direction of economic growth."

http://www.ny.frb.org/rmaghome/staff_rp/sr83.pdf


The excerpt below is from a FAQ (Frequently Asked Questions) page on the U.S. Treasury's web site. The question being answered is "Why don't we just print all of the money we need to pay off the debt or to pay for government services?" "Many people do not realize that when the Federal Government runs a deficit, it does not create money for itself to make up the difference. The Government finances the budget debt by issuing and selling bonds to the public. In addition, the Treasury Department does not print money to cover budget deficits. You may be interested to know that the only types of money that the United States issues directly through the Treasury Department are United States notes and United States coinage. While the Treasury's Bureau of Engraving and Printing (BEP) produces Federal Reserve notes, the Board of Governors of the Federal Reserve System issues them into circulation. The vast majority of currency notes in circulation today are Federal Reserve notes. In short, the Federal Reserve Board has primary responsibility for the control of the Nation's money supply, whether there is a budget deficit or not.

It is important to keep in mind that neither money-financed nor bond-financed deficits are appropriate for dealing with the Federal budget deficit. The immediate effect of financing the deficit by printing new money may be to keep interest rates lower than they otherwise would be. As time progresses, however, the excess money introduced into the economy leads to higher inflation and invariably to higher interest rates. So simply put, printing money to finance the deficit may not cause the Federal debt and debt interest payments to grow. It does generate higher inflation and rising interest rates over time.

The preferred solution for dealing with the Federal budget deficit is to maintain a balanced Federal budget as much as possible. This requires that all U.S. Government spending be matched dollar-for-dollar by tax revenues whenever possible. This approach to budget management would reflect fiscal responsibility, but also provide a straightforward and honest way of informing taxpayers of their current and future tax liabilities."

http://www.ustreas.gov/opc/opc0037.html


The following is excerpted from the website of the Federal Reserve Bank of San Francisco. It is from a section called “Fun Facts About Money” and describes the process by which money is printed.

“Since October 1, 1877, all U.S. currency has been printed by the Bureau of Engraving and Printing, which started out as a six person operation using steam powered presses in the basement of the Department of Treasury. Now, 2,300 Bureau employees occupy twenty-five acres of floor space in two Washington, D.C. buildings. The Treasury also operates a satellite printing plant in Ft. Worth, Texas. Currency and stamps are designed, engraved, and printed twenty-four hours a day on thirty high speed presses. In 1990, at a cost of 2.6 cents each, over seven billion notes worth about $82 billion were produced for circulation by the Federal Reserve System. Ninety-five percent will replace unfit notes and five percent will support economic growth. At any one time, $200 million in notes may be in production. Notes produced in 2002 were the $1 note, 41% of production time; the $5 note, 19%; $10 notes, 16%; $20 note, 15%; and $100 note, 9%. No $2 or $50 notes were printed in 2002.”

http://www.frbsf.org/federalreserve/money/funfacts.html



The following perspective is excerpted from a speech given by then Federal Reserve Governor Ben Bernanke at the Meetings of the American Economic Association in San Diego, California, on January 4, 2004. In the excerpt below he discusses the effectiveness of M2 money supply growth rates as a predictor for future inflation rates:


"I haven't said anything yet about the rate of growth of the money supply, another indicator that is sometimes cited by those concerned about inflation, largely because there is not too much to say. Growth in standard monetary measures such as the base and M2 has been moderate (and declining) in recent years, certainly well within expected ranges given the growth of nominal GDP and normal variation in velocity. For example, for 2003 as a whole, growth in both the monetary base and M2 should be about equal to growth in nominal GDP. Even should money growth rates accelerate, however, I would caution against making strong inferences about the likely behavior of inflation, except in the very long run. Money growth has not proven to be especially useful for predicting inflation in the short run, in part because various institutional factors unrelated to monetary policy often affect the growth rate of money. A striking example of the way special factors can affect money growth rates is the fact that M2 growth has actually been sharply negative, at about -5 percent at an annual rate, for the past three months for which data are available. Factors such as the falloff in mortgage refinancing activity and outflows from retail money market funds into equities and other investments are the proximate explanations for the decline in M2. Certainly, this short-term decline in broad money is not to be taken as evidence of tight monetary policy!"

http://www.federalreserve.gov/boarddocs/speeches/2004/20040104/default.htm


The following passage is from a staff report issued by the Federal Reserve Bank of New York titled "What Was Behind The M2 Breakdown?" It was written by Cara S. Lown, Stavros Peristiani, and Kenneth J. Robinson. In it they discuss the usefulness of M2 as an indicator of the rate of economic growth:

"There has been a long-running debate over the usefulness of monetary aggregates as intermediate targets or information variables in the conduct of monetary policy. This issue has remained timely. The European Central Bank, for example, is reviewing whether to target a monetary aggregate or inflation in its implementation of monetary policy (Svensson, 1999). In the U.S., most recently Feldstein and Stock (1994) argued that the Federal Reserve should use the M2 monetary aggregate as an intermediate target. On the other hand, there has been a fair amount of work suggesting that M2 is not reliable as either a target or an indicator of monetary policy. Friedman and Kuttner (1992) argued that by the early 1990s the relationship between M2 and GDP had weakened, and Estrella and Mishkin's (1998) work provided further support for this finding. In this paper, we show that depository institutions' capital difficulties during the late1980s and early 1990s can account for a substantial part of the deterioration in the link between M2 and GDP. With these problems now behind us, the link between M2 and economic growth has strengthened. An implication of our findings is that it may be premature to abandon M2 as an indicator of aggregate real activity. In particular, in the absence of financial sector difficulties, a monetary aggregate such as M2 could possibly provide useful information about the future direction of economic growth."

http://www.ny.frb.org/rmaghome/staff_rp/sr83.pdf


The excerpt below is from a FAQ (Frequently Asked Questions) page on the U.S. Treasury's web site. The question being answered is "Why don't we just print all of the money we need to pay off the debt or to pay for government services?"

"Many people do not realize that when the Federal Government runs a deficit, it does not create money for itself to make up the difference. The Government finances the budget debt by issuing and selling bonds to the public. In addition, the Treasury Department does not print money to cover budget deficits. You may be interested to know that the only types of money that the United States issues directly through the Treasury Department are United States notes and United States coinage. While the Treasury's Bureau of Engraving and Printing (BEP) produces Federal Reserve notes, the Board of Governors of the Federal Reserve System issues them into circulation. The vast majority of currency notes in circulation today are Federal Reserve notes. In short, the Federal Reserve Board has primary responsibility for the control of the Nation's money supply, whether there is a budget deficit or not.

It is important to keep in mind that neither money-financed nor bond-financed deficits are appropriate for dealing with the Federal budget deficit. The immediate effect of financing the deficit by printing new money may be to keep interest rates lower than they otherwise would be. As time progresses, however, the excess money introduced into the economy leads to higher inflation and invariably to higher interest rates. So simply put, printing money to finance the deficit may not cause the Federal debt and debt interest payments to grow. It does generate higher inflation and rising interest rates over time. The preferred solution for dealing with the Federal budget deficit is to maintain a balanced Federal budget as much as possible. This requires that all U.S. Government spending be matched dollar-for-dollar by tax revenues whenever possible. This approach to budget management would reflect fiscal responsibility, but also provide a straightforward and honest way of informing taxpayers of their current and future tax liabilities."

http://www.ustreas.gov/opc/opc0037.html

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