Definitions of money supply

money supply
money supply

The supply of money is a stock at a particular point of time, though it conveys the idea of a flow over time. The term money supply is synonymous with such terms as money stock, stock of money, money supply and quantity of money.

The supply of money at any moment is the total amount of money in the economy. There are three alternative view regarding the definition or measures of money supply.


The first definition of money supply:


The most common view is associated with the traditional and Keynesian thinking which stresses the medium of exchange function of money. According to this view, money supply is defined as currency with the public and demand deposits with commercial banks. Demand deposit is savings and current accounts of depositors in a commercial bank.

They are the liquid form of money because depositors can draw cheques for any amount lying in their accounts and the bank has to make immediate payment on demand. Demand deposits with deposits with commercial banks plus currency with the public are together denoted as M1, the money supply. This is regarded as a narrower definition of the money supply.


The second definition of money supply:


The second definition is broader and is associated with the modern quantity theorists headed by Friedman who is an economist. Friedman defines the supply of money at any moment of time as “literally the number of dollars people are carrying around in their pockets, the number of dollars they have in their credit at bank or dollars they have to their credit at banks in the form of demand deposits, and also commercial bank time deposit.” Time deposit are fixed deposit if customers in a commercial bank. Such deposits earn a fixed rate of interest varying with the time period for which the amount is deposited. Money can be withdrawn before the expiry of that period by paying a penal rate of interest to the bank. So time deposit possesses liquidity and is included in the money supply according to Friedman.

Thus this definition includes M1 plus time deposits of commercial banks in the supply of money. This wider definition is characterized as M2 in America and M2 in Britain. It stresses the store of value function of money or what Friedman says a temporary abode of purchasing power.


The third definition of money supply:


The third definition is the broadest and is associated with Gurley and Shaw a renowned economists. They include in the supply of money, M2 plus deposits of saving banks, building societies, loan associations, and deposits of other credit and financial institutions.

The choice between these alternative definitions of the supply of money supply depends on two considerations;

1.      A particular choice of definition may facilitate or blur the analysis of the various motive for holding cash or money.

2.      From the point of view of monetary policy an appropriate definition should include the area over which the monetary authorities can have direct influence. If these two criteria are applied, none of the three definitions is wholly satisfactory.


The first definition of money supply may be analytically better because M1 is a sure medium of exchange. But M1 is an inferior store of value because it earns no rate of interest, as it earned by time deposits. Further, the central bank can have control over a narrower area only demand deposits are included in the money supply.


The second definition that includes time deposit M2 in the supply of money is less satisfactory analytically because “in a highly developed financial structure, it is important to consider separately the motives for holding money and means o payment and time deposit”. Unlike demand deposit, time deposits are not a perfect liquid form of money. This is because the amount lying in them can be withdrawn immediately by cheques.

Normally, it cannot be withdrawn before the due date of expiry of deposit. In case a depositor wants his money earlier, he has to give a notice to the bank which allows the withdrawal after charging a penal interest rate from the depositor. Thus time deposits lack perfect liquidity and cannot be included in the money supply. But this definition is more appropriate from the point of view of monetary policy because the central bank can exercise control over a wider area that includes both demand and time deposits held by commercial banks.


The third definition of money supply that includes M2 plus deposits of non bank financial institutions is unsatisfactory on both the criteria. Firstly, they do not serve the medium of exchange function of money. Secondly, they almost remain outside the area of control of the central bank. The only advantage they posses is that they are highly liquid store of value. Despite this merit, deposits of non bank financial institutions are not included in the definition of money supply.


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