Money Supply Measures & Monetary Policy
Money supply measures are statistical indicators used to track the amount of money in circulation in an economy. These measures indicate how the economy is doing and give important information about the financial system's health and stability. Central banks, statistical agencies, and other government bodies publish money supply figures which economists, policymakers, and financial market participants closely monitor.
M0, M1, M2, and M3 are the most commonly used money supply measures. These measures differ in terms of the types of money they include and the level of liquidity they represent.
What are M0, M1, M2 & M3 ?
M0, the monetary base, is the total amount of cash in circulation plus the reserves that commercial banks hold at the central bank. M1 includes M0 plus the most liquid forms of money, such as checking accounts, traveler's checks, and other forms of demand deposits. M2 includes M1, plus savings deposits, time deposits, and money market mutual funds. Finally, M3 includes M2, plus large-time deposits, institutional money market funds, and other forms of less liquid money.
FX traders are primarily interested in M1 and M2, as these measures provide insight into the amount of money available for spending and investment. When M1 and M2 increase, it is generally seen as a bullish signal for the economy, indicating that more money is available for investment and consumption. Conversely, when M1 and M2 decrease, it is seen as a bearish signal, as it suggests less money is available for spending and investment.
In addition to M1 and M2, many traders pay close attention to the velocity of money, which measures the rate at which money changes hands in the economy. When the velocity of money is high, it suggests that money is being spent and invested quickly, which is a bullish signal. Conversely, when the velocity of money is low, it indicates that money is being held onto or invested less frequently, which can be seen as a bearish signal.
Who controls the money supply?
Central banks use tools like open market operations, reserve requirements, and the discount rate to control the amount of money in circulation.
Open market operations involve the central bank buying or selling government securities in the open market, which affects the amount of money in circulation. When the central bank buys government securities, it injects money into the economy and increases the money supply. Conversely, when it sells government securities, it removes money from circulation and decreases the money supply.
Reserve requirements require commercial banks to hold a certain percentage of their deposits as reserves at the central bank. By increasing or decreasing reserve requirements, the central bank can control the amount of money banks can lend, affecting the overall money supply. When reserve requirements are increased, banks must hold more reserves and have less money available to lend, which decreases the money supply. On the other hand, when reserve requirements are lowered, banks have more money to lend, which increases the amount of money in circulation.
The discount rate is the interest rate at which commercial banks can borrow money directly from the central bank. By raising or lowering the discount rate, the central bank can incentivize banks to borrow more or less money, which affects the amount of money in circulation. For example, when the discount rate is high, banks are less likely to borrow money, which decreases the money supply. Conversely, when the discount rate is low, banks are more likely to borrow money, which increases the money supply.
In addition to these policy tools, central banks can influence the money supply through their communication and guidance to financial markets. For example, by signaling that they will pursue an accommodative monetary policy, central banks can encourage borrowing and investment, increasing the money supply.
Interest Rates & Monetary Policy
Interest rates are a crucial tool of monetary policy that central banks use to influence economic activity. Monetary policy refers to the actions central banks take to manage the money supply, credit, and interest rates to achieve their macroeconomic goals. Typically, central banks aim to achieve price stability, maximum employment, and sustainable economic growth through their monetary policy.
Central banks influence interest rates by adjusting the target for their key policy rate. This rate, known as the federal funds rate in the United States, is the interest rate banks lend to each other overnight. By changing the federal funds rate, the central bank can influence other short-term interest rates, such as the prime rate, affecting borrowing costs for households and businesses.
When the central bank lowers interest rates, it becomes cheaper for households and businesses to borrow money, stimulating spending and investment. Lower interest rates also reduce the cost of financing government debt, encouraging government spending. This can lead to an increase in economic activity and employment.
Conversely, when the central bank raises interest rates, it becomes more expensive for households and businesses to borrow money, which can reduce spending and investment. Higher interest rates can also make it more costly for governments to finance their debt, which can reduce government spending. This can lead to a decrease in economic activity and employment.
Aside from directly changing interest rates, central banks can use other monetary policy tools to reach their goals. These include open market operations, in which the central bank buys or sells government securities to change the amount of money in circulation; reserve requirements, which tell banks how much money they must keep in reserve; and forward guidance, which describes what the central bank plans to do with monetary policy in the future.
Currency exchange rates:
Central bank policies can influence currency exchange rates, which can significantly impact trade and capital flows between countries. For example, if a central bank lowers interest rates compared to other countries, it can make its currency less appealing to investors and cause it to lose value. This could make exports cheaper and imports more expensive, which could improve the country's trade balance. However, it can also make it more difficult for the country to attract foreign investment.
Global financial stability:
Changes in monetary policy can also impact global financial stability, as actions taken by one central bank can have knock-on effects on other countries and markets. For example, a decision by the U.S. Federal Reserve to raise interest rates can lead to higher borrowing costs for emerging market economies, potentially leading to financial stress and instability.
Overall, central bank policies can impact financial markets in various ways. As a result, traders need to pay close attention to these policies and their potential impacts on the broader economy and financial system.