Money Supply (M2)


Current Status and Perspectives

August 2003
Total Money Supply M2, August 2003:
$6133 billion
Annualized Growth Rate for M2, August 2003 (relative to August 2002):
Review the latest Money Supply (M2) data (Available at Economagic)

The following perspective is excerpted from a speech given by Federal Reserve Chairman Alan Greenspan at a symposium sponsored by The Federal Reserve Bank Of Kansas City in Jackson Hole, Wyoming on August 29, 2003. In it he describes the role of the money supply in the overall monetary policy of the Federal Reserve:

"Recent history has reinforced the perception that the relationships underlying the economy's structure change over time in ways that are difficult to anticipate. This has been most apparent in the changing role of our standard measure of the money stock. Because an interest rate, by definition, is the exchange rate for money against non-monies, money obviously is central to monetary policy. However, in the past two decades, what constitutes money has been obscured by the introduction of technologies that have facilitated the proliferation of financial products and have altered the empirical relationship between economic activity and what we define as money, and in doing so has inhibited the keying of monetary policy to the control of the measured money stock. Nonetheless, in the tradition of Milton Friedman, it is difficult to disregard the long-run relationship between money and prices. In particular, since 1959 unit money supply, the ratio of M2 to real GDP, has increased at an annual rate of 3.7 percent and GDP prices have risen 3.8 percent per year."

The following excerpt is from a speech by Kazuo Ueda, Member of the Policy Board of the Bank Of Japan, at the semi-annual meeting of the Japan Society of Monetary Economics held at Fukushima University in Fukushima City on September 29, 2001. In it he discusses the situation in recent Japanese monetary policy in which the economy has fallen into a "liquidity trap", where nominal interest rates have fallen to zero. Consequently, the central bank has no room to stimulate the economy by lowering interest rates.

"Normally, an increase in the monetary base induces declines in interest rates, which in turn stimulate the demand for goods and services. The increase in the monetary base supports lending by financial institutions to firms and households purchasing goods and services. However, this mechanism has been impaired since the mid 1990s because of very low interest rates and the non-performing loan problem. In the following I will discuss the Bank of Japan's monetary policy mostly in relation to the first of the two constraints, i.e., the zero bound on nominal interest rates. The "liquidity trap" has been defined in many different ways, generating some confusion. Here I would like to simply define a liquidity trap as a situation where there is no room for nominal interest rates to decline. According to this definition, Japan's money market has been nearly in a liquidity trap for a few years. As for long-term interest rates, however, it is difficult to judge whether they can decline any further beyond recent levels.

"Three options for further monetary easing can be considered when money market interest rates are near zero. First, if the short-term rate is very low but not zero percent, the rate can be lowered further to as close to zero as possible by increasing the monetary base. Second, the BOJ (Bank Of Japan) can influence expectations of economic entities by promising to continue monetary easing into the future. Some have called this the commitment or policy duration effect. Third, the BOJ can carry out unconventional operations by purchasing assets other than short-term Japanese government securities… it is possible to reduce money market interest rates to as close to zero as possible by increasing the monetary base until the economy falls literally into a liquidity trap. After entering the trap, it becomes almost meaningless to merely increase the monetary base. People hold money instead of short-term financial assets as they derive utility from the liquidity of money even at the cost of forgone interest. In equilibrium, the marginal utility of holding more money and the opportunity cost of holding money instead of interest-bearing assets, that is, the nominal interest rate, must be the same. Thus, when money market interest rates are virtually zero, the marginal utility of holding the monetary base is almost zero, which means, it is simply meaningless to supply more money, or people are satiated with the liquidity service money provides. In fact, undersubscription, the situation where the total amount of bids in money market operations falls short of the total offer, has been frequently observed in the Bank of Japan's funds-supplying operations."

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."

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."

Alan Greenspan discusses the shortcomings of economic forecasting models in relation to monetary policy in this excerpt of a speech given on October 19, 2000 at the 18th Annual Monetary Conference at the Cato Institute in Washington, DC.

"Whether we choose to acknowledge it or not, all policy rests, at least implicitly, on a forecast of a future that we can know only in probabilistic terms. Even monetary policy rules that use recent economic outcomes or money supply growth rates presuppose that the underlying historical structure from which the rules are derived will remain unchanged in the future. But such a forecast is as uncertain as any. This uncertainty is particularly acute for rules based on money growth. To be sure, inflation is at root a monetary phenomenon. Indeed, it is, by definition, a fall in the value of money relative to the value of goods and services. But as technology continues to revolutionize our financial system, the identification of particular claims as money, near money, or a store of future value has become exceedingly difficult. Although it is surely correct to conclude that an excess of money relative to output is the fundamental source of inflation, what specifically constitutes money is a notion that has, so far, eluded our analysis. We cope with this uncertainty by ensuring that money growth, by any reasonable definition, does not reach outside the limits of perceived prudence. But we have difficulty defining those limits with precision, and within any such limits, there remains significant scope for discretion in setting policy. In history, discretionary monetary policy, of course, has not been without its shortcomings, and the dominant force of accelerating productivity has made our current task of policy calibration especially daunting. Policymakers, in fact all forecasters, invariably construct working hypotheses or models of the way our economies work. Of necessity, these models are a major simplification of the many forces that govern the functioning of our system at any point in time.

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