See full list on corporatefinanceinstitute.com. The quantity theory of money assumes that velocity is constant, which implies that real money demand is proportional to real income and is unaffected by the real interest rate. Equilibrium in the asset market is described by the condition that real money supply equals real money demand because when supply equals demand for money, demand must.

Macroeconomic theory is the study of various economic factors that include information on aggregated indicators. These factors commonly include a government’s fiscal or monetary policy, which can include information on the money supply and interest rate that drives a market’s liquidity. Money supply refers to how much capital exists in a market that an individual or business can use to engage in financial transactions. Interest rates are the “fees” associated with loans, whether to consumers or between commercial banks. In most economies, a central bank or government agency is responsible for watching over both and adjusting policies as necessary.

Commercial banks play an integral role in the banking system of an economy. They are the primary institutions responsible for accepting customer deposits, making loans to individuals and businesses, and providing other critical financial services. Commercial banks typically operate under a fractional reserve system in which central banks will set a reserve percentage for them. This reserve percentage is the amount of actual cash the bank must have in its coffers at all times. For example, if the central bank sets the reserve percentage at 5% and a bank has customer deposits of $1 million US Dollars (USD), the bank is only required to keep $50,000 USD in its facility (0.05 x 1,000,000).

Fractional reserve banking affects money supply because the central bank can increase the supply of money by lowering the reserve percentage, say to 4%. This allows individuals and businesses to increase their financial transactions. Raising the reserve percentage will have the opposite effect, removing money from the economy and tightening the money supply.

For the second half of the money supply and interest rate theory, central banks typically set one or two different interest rates in an economy. The first is known as the target interest rate, and banks charge each other this rate when making loans amongst themselves and the central bank. In theory, higher target interest rates mean that banks will have to pay more money on their loans, decreasing the money supply available to consumers.

Central banks can also influence consumer interest rates, which is the amount a bank will charge individuals and businesses for loans. When consumers have to pay more money from higher interest rates, it will reduce the money supply and create a tighter economic market. Raising interest rates is also a common way for the central bank to curb inflation in an economy.

Your question highlights a common misconception about how the Fed conducts monetary policy. For a period of time, the Fed did in fact implement monetary policy by controlling the monetary aggregates (the quantity of money). However, developments in the financial services industry, changes in the relationship between the money supply and the economy, as well as changes in views on monetary policy, eventually led to the Fed reverting back to implementing monetary policy through changes in interest rates (the price of money). 1

What are the monetary aggregates, and why does the Fed still care about them?

Though the Fed no longer implements changes in monetary policy by controlling the growth rate of the money supply, the monetary aggregates are still monitored by economists as an indicator of future economic activity. One measure of the money supply, real or inflation-adjusted M2, is classified as a leading economic indicator. In order from most narrow to most broad, the three nominal monetary aggregates published weekly by the Federal Reserve Board in the H.6 Release,Money Stock Measures are: 2

M1: The most liquid forms of money including currency in the hands of the public, travelers checks, demand deposits, and other deposits against which checks can be written.
M2: M1, plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds.
M3: M2, plus large-denomination ($100,000 or more) time deposits, balances in institutional money market mutual funds, repurchase liabilities issued by depository institutions, and Eurodollars held by U.S. residents at foreign branches of U.S. banks and at all banks in the United Kingdom and Canada.

When the money supply grows, consumers and businesses have relatively more money in their hands with which to purchase goods and services. Therefore, in theory, faster money supply growth should be associated with faster economic growth after a short lag of perhaps two or three quarters. However, many important changes in how financial assets are held by the public have changed over time and the relationship between money supply growth rates and the economy has deteriorated.

Why doesn’t the Fed still conduct monetary policy by controlling the size of the monetary aggregates?

Real Interest Rate And Money Supply Graph

The Fed’s Purposes and Functions (2005) publication describes the change that has occurred over time in the relationship between monetary aggregates and Gross Domestic Product (GDP):

“[T]he relation between the growth in money and the growth in nominal GDP, known as ‘velocity,’ 3 can vary, often unpredictably, and this uncertainty can add to difficulties in using monetary aggregates as a guide to policy. Indeed, in the United States and many other countries with advanced financial systems over recent decades, considerable slippage and greater complexity in the relationship between money and GDP have made it more difficult to use monetary aggregates as guides to policy. In addition, the narrow and broader aggregates often give very different signals about the need to adjust policy. Accordingly, monetary aggregates have taken on less importance in policy making over time.”

Interest Rates And Inflation

Historical growth of money and the economy

Real Interest Rate And Money Supply Formula

Below is a simple comparison of the growth rates of the real M2 and real growth rates of the U.S. economy; the gray bars represent periods of recession as defined by the National Bureau of Economic Research (NBER). This graph illustrates how the relationship between money growth and the economy has changed over time.

The chart displays the “before” period, when monetary policy focused on the monetary aggregates, which ended in the mid-1980s, as well as the “after” period, when the importance of monetary aggregates as indicators of future economic performance diminished. From 1960 until the mid-1980s, each recession is preceded by a sharp decline in the growth rate of real M2. However, in the period after the mid-1980s, the correlation between the growth rate of real M2 and the economy is much weaker.

Changing financial services

One of the key factors behind the change in the relationship between money and the economy has been the significant changes in the financial services industry over the years. New banking laws and the development of new types of financial assets and products have blurred the distinctions between balances counted in the monetary aggregates and other types of financial assets. In short, these developments brought about significant changes in the way people hold money and other types of financial assets. For example, monitoring the monetary aggregates for clues to future economic performance became much more difficult once savers could frequently and cheaply shift between balances counted in M2 (like money market mutual fund shares) and other financial balances that are not counted in the money aggregates (such as mutual fund shares). Moreover, even the relationship