Ihab Itani

Macroeconomics

March 12, 2014

Assignment 4

Money Supply within an Economy

In each country, it is important that the governing body be aware of just how much

money is circulating within their economy. Knowing this information can help

economic analysts provide valuable information such as the current economic

health, potential problems that might arise, economic forecast and many others.

Therefore the money supply measurements have been created. Within every

economy, there are six ways in which the currency circulating within the economy

can be categorized, however for this particular task only two of the categories will be

explained more in detail.

One of the ways in which the currency within an economy is categorized is through

the classification of M1. The M1 measurement calculates the sum of all coins,

currency in possession by public, traveler`s check, checking account balances,

automatic transfer service accounts, and balance in credit unions. The other, broader

way in which currency is categorized is through the M2 measurement system. M2

consists of all the previously stated currency forms in M1, as well as highly liquid

banks accounts used for short-term saving. These added assets included savings

deposits, money market deposits, certificates for deposits, and money market mutual

funds.

As a result, many economists tend to agree that M2 is far an enhanced level of

measurement than M1 for the amount of the currency circulating within an economy.

The main reason why M2 is considered to be better indication of the quantity of

money flowing in the economy is due to the fact that M2 includes the value of M1 as

well as bank accounts that can easily, as well as rapidly, be converted into their

currencies or checking deposits. Often, consumers take into consideration that their

consumption can be paid off through their checking account M1 as well as their

savings accounts M2 and thus M2 can provide a more accurate value of currency

circulating within an economy. For this reason, government tends to focus more on

M2 rather than M1 when dealing with situations that include the money flow within

the economy.

When the central bank of an economy decides to buy bonds in the open market

during a recession, what happens to the supply of money is that it increases,

eventually leading to the decline in the “price” of the money to fall. The following

graph will demonstrate the effect on the money supply when the central bank buys

bonds. As shown, the purchase of bonds increases the money supply within the

economy, as you can see the shift in MS

curve, from MS1 to MS2. This leads to a

decrease in the interest rates shown by the

decrease from r1 to r2. This decrease in the

interest rate leads to an increase in the

quantity of money, therefore proving that

when the central bank purchases bonds,

the overall money supply will increase.

In an occasion that the central bank decides to maintain or hold their current levels of

interest rates during inflation, the money supply would decrease because of the loss

of borrowing power from the consumers.to save rather than spend their income will

increase, lowering the amount of money circulating within the economy.

The following graph shows the effects of maintained interest rates during an inflation

period.

As we can see, the maintained

level of interest rates leads to a

decrease in the money supply

shown by the shift in the money

supply curve from MS1 to MS2.

Additionally, since the consumers

have experienced a loss of

borrowing power, the demand for money will decrease, shown by the shift in the

demand curve from D1 to D2.

When the central bank decides to increase the reserve requirement during a period

of inflation, what basically happens is that money flowing within the economy is

taken out in order to be placed in the banks’ reserves. When this happens, the

money supply decreases, which leads to an increase in the interest rates.

The effects of this can be seen in the graph below.

Since the increase in the reserve

requirement means that the

central bank is trying to slow down

economic growth the interest rates

will increase, increasing the

motivation for consumer’s to save

rather than spend. This increase in

the interest rate has moved from

r1 to r2, and the change from M1

to M2 shows the decrease in the

quantity of money.