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Q5. What is money supply? How might it be controlled by the authorities? What forces in the economy tend to bring money supply and money demand into equilibrium?

Money is always difficult to define and different definitions are available to catch the different degree of liquidity of a range of financial assets. The narrowest definition is:

M0 = notes and coins held by the public and commercial banks balances with the central bank.

This definition can be widened to include several types of deposit of banks, financial institutions and building societies.

Money supply is the amount of money that the central bank decides to provide to the economic system. The central bank has the legal power of printing and supplying money: in this sense money is determined exogenously, outside the economic system (MS is vertical in figure 11.2). In modern economies, commercial banks have the possibility to increase money supply through deposit-creation.  The advent of new technology has made the process of controlling money supply increasingly complex.  As explained at p. 342, the instruments in central bank's hands to change money supply are the following:

i)  Change in the minimum amount of reserves (monetary base) that banks have to hold in order to lend money.

ii)  Open market operations.

iii) Change in the discount rate, the official rate of interest charged to commercial banks when they borrow money from the central bank.

The money market works as any other market with a price clearing supply and demand. The price of money is the interest rate. If the interest rate was above the equilibrium level, there would be excess of supply and this would lead down the price of money until supply would meet demand.

We have to be aware of the movements of both money supply and money demand. Money supply can change because of open market operations and, in small open economies, because of the change in the world interest rate. Any increase in Money supply pushes down the equilibrium interest rate to r1 (in figure 11.2, the equilibrium moves from point A to point B), as any decrease pushes interest rate up.

Money demand can shift because of changes in income, price level and velocity of money (see question 4). For example a growth in income increases the demand for real money balances: MD moves outwards and the equilibrium is restored through an increase in the interest rate to r2 (point C in figure 11.2).


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