Money supply tells a lot about the prevailing economic conditions.
In the previous blog on Understanding Monetary Policy, the author told how monetary policy relates to the money supply in a nation’s economy. One thing is clear, for the monetary policy to be effective, the money supply must be checked, measured, and regulated. The last task is unthinkable without performing the preceding two. As far as measuring the money supply is concerned, these are some of the questions that might have struck your mind:
- How is the money supply measured?
- Is it even possible to measure money supply in a cash-infested economy with fewer electronic transactions, like Pakistan?
- Is there any determinant or measurement unit for measuring the money supply?
- Is the measurement overall or done in parts?
Measuring the Money Supply
One of the problems faced when defining money is that although money characterizes itself by its universal acceptance, “no single definition of money has been universally-acceptable.” ( Monetary Aggregates: A User’s Guide). Hence, there exists no single determinant for measuring the money supply. The following types of money possess their own and shared characteristics. What distinguishes them from one another is that they vary from extreme narrowness to extreme broadness in their scope. Apart from all M’s, an anomaly in the form of L exists. It is the fifth type of money, but we won’t touch it now. Summing it up:
Types of Money
Following are the types (not forms) of money:
Approaches to Measuring Money Supply
There are two fundamental approaches to defining the measure of money:
- Transactions approach (corresponds to M1)
- Liquidity approach (corresponds to M2)
Since the above two approaches correspond to their respective types of money, we will not discuss them separately to avoid confusion.
Also called the reserve money, M0 comprises money issued by the central bank. As the ‘bank of issue,’ the central bank possesses the sole authority to print money (or mint them, in the case of coins) which acts as ‘legal tender.’ The central bank issues cash that provides instant purchasing power to the bearer. The State Bank of Pakistan issues currency notes in Rs. 10, 20, 50, 100, 500, 1000, and 5000 denominations. The State Bank has 04 issue offices in Karachi, Lahore, Quetta, and Peshawar.
Moreover, M0 comprises commercial bank reserves held in the central bank. As the ‘banker’s bank’ and the ‘lender of last resort,’ the central bank provides financing to commercial banks at discounted rates. The Cash Reserve Ratio (CRR) also falls in M0.
As mentioned in the previous blog on Money: Myths and Misinformation, one of the essential characteristics of money is being a medium of exchange during transactions, including but not limited to buying and selling. Hence, also referred to as the transactions approach to measuring money, economists in favor of M1 treat money narrowly merely as a medium of exchange used to fulfill monetary transactions (as Aristotle treated it). M1 inherits all characteristics from M0.
Higgins and Faust, in this publication, shed more light on the transactions approach in the following terms:
“The transactions approach to defining money assumes that assets performing as a medium of exchange are qualitatively different from other assets. Whereas all assets serve as a store of value, only a limited number is generally accepted as a means of payment.”
Additionally, cash deposits in checking (current) accounts are a part of M1. Since no maximum withdrawal and transaction limit exists in regular checking accounts, one can obtain instant purchasing power.
Traveler’s cheques also fall in M1. They are a credit facility provided by the banks to their customers who plan on traveling internationally and do not want the hassle of cash handling. MCB, UBL, and JS Bank issue traveler’s cheques.
Can you think of more means of providing instant purchasing power? If you use either an ATM card or a debit card, you gain instant purchasing power.
Is M1 An Outdated Measure of Money Supply?
At least not in Pakistan. Pakistan is a cash-infested economy. Even at least 90 percent of entire eCommerce deliveries are COD (Cash On Delivery). Moreover, the increasing M1 in the following graph reflects the significance of the transactions approach:
Enter yet another essential characteristic of money: store of value. As mentioned in the previous blog on Money: Myths and Misinformation, precious metals, mainly gold and silver, served the medium of exchange role of money in older times. In short, they were the most liquid assets of that time. However, today cash has dethroned gold and silver as the most liquid asset available, providing instant purchasing power. M2 paints a picture of the willingness to spend, holding slightly less liquid assets.
Higgins and Faust describe the liquidity approach as:
“The liquidity approach stresses the store of value function rather than the medium of exchange function emphasized in the transactions approach. The liquidity approach assumes that money is not qualitatively different from other assets. Instead, liquidity is a property of all assets to some degree.”
“In Pakistan, M2 is the most widely used definition of broad money,” as per the State Bank. Also called the liquidity approach to measure money, M2 includes all characteristics of M1 and slightly liquid assets that do not provide instant purchasing power, unlike cash. However, one can readily encash (liquefy) M2 with less time and effort to gain purchasing power. M2 includes assets such as gold and silver, overnight repurchase agreements, small-denomination term (fixed) deposits, etc.
In addition, M2 comprises savings account deposits. A bar on the maximum withdrawal and transaction exists in a savings account.
M3 is an even broader definition of money and includes all characteristics of M2 and less liquid assets. One cannot readily liquefy such assets. Hence, it is comparatively quite cumbersome to obtain purchasing power. M3 comprises term-based repurchase agreements, large-denomination term deposits, etc.
Can you think of more assets that are hard to liquefy? Real estate is one of them. It takes time and effort to find the right buyer willing to purchase property at the right price and make the payment accordingly.