The term money supply is just what it sounds like; the total amount of money in our economic system. More specifically, money supply includes all electronically held deposit balances within any banking institutions account plus all coins and bills that are in circulation. To get more detailed, the federal reserve has created different classes of money to measure outstanding money. There are four classes; M0, M1, M2, and M3 and they are primarily segregated by levels of liquidity.
M0 represents all of the physical cash and coins in public circulation plus any accounts held at central banks which can be exchanged for cash.
M1 includes M0 plus any balances that are in checking accounts or any other demand accounts (accounts that allow you to exchange for cash
M2 includes M1 plus small CD's, many savings accounts, and money market accounts
M3 includes M2 plus all CD's not included in M2, eurodollar deposits and Repos.
How does the Fed Control Money Supply?
As we discussed earlier, the money supply is an important piece of the puzzle to maintain economic balance and if this does not happen, a recession can take hold.
When there is a heavy injection of money supply into our monetary system, known as "loosening", inflation will be the result. Remember the supply/demand construct; when people have more money to spend, higher prices for the consumer will result. Reducing the money supply by increasing the "reserve requirement", referred to as "tightening", requires the banks to hold more in federal funds which reduces their leverage ratio. The leverage ratio measures the banks ability to leverage their demand deposits as loans.
The Fed can also use the treasury auctions to expand and contract the money supply. When the Fed sells treasury bills, notes, and bonds, they are essentially pulling money out of the system and issuing a security in its place. This security does not count as part of the money supply equation. Conversely, when the Fed conducts buybacks, they are buying the securities back and returning principal to the security holders. This increases the money supply.
Finally, another very important means of controlling the money supply is through moving the interest rates up and down. The fed moves the discount rate and federal funds rate up to tighten money supply by discouraging borrowers from taking loans. This will occur to keep inflationary pressures in check. Conversely, by moving the rates lower, the Fed is attempting to stimulate the economy by encouraging borrowers to take new loans.
In conclusion, the Fed has a serious task at hand in monitoring and maintaining a fine balance in money supply. The financial climates of 2000 and 2007 are two great examples of what happens when the Fed loses control.