What happens when the money supply is decreased?

What is one of the leading causes of inflation? What happens when you have too many dollars flowing into the economy? Who is in charge of printing US dollars? Can the US print as many dollars as it wants? You will be able to answer all these questions once you read our explanation of the money supply!

Money Supply: Definition

The money supply is defined as the total amount of currency and other liquid assets such as checkable bank deposits circulating in a country's economy. In most economies in the world, you have either the government or the central bank of a country in charge of the money supply. By increasing the money supply, these institutions provide more liquidity to the economy.

The institution in charge of the money supply in the US is the Federal Reserve. By using different monetary tools, the Federal Reserve makes sure that the money supply in the US economy is kept under control.

There are three main tools that the Federal Reserve uses to control the money supply in the economy:

• open-market operations

• reserve requirement ratio

• the discount rate

To learn how these tools work in action, check our explanation on the Money Multiplier.

The Money Supply is the sum of checkable or near checkable bank deposits plus currency in circulation.

Figure 1 above shows the relationship between the money supply and the monetary base.

Examples of money supply

Examples of money supply include:

• the amount of currency that circulates in the economy
• checkable bank deposits

You can think of money supply as any type of asset in the economy that can be converted into cash to make payments. However, there are different methods of measuring the money supply, and not all the assets are included.

To understand how the money supply is calculated and what it includes, check our explanation - Measuring the Money Supply

Banks and the Money Supply

Banks play an essential role when it comes to the money supply. An important distinction is that the Fed acts as a regulator while the banks carry out the regulations. In other words, the Fed's decision impacts banks, thereby impacting the money supply in an economy.

To learn more about the Fed, check our explanation on The Federal Reserve.

Banks influence the money supply by taking out of circulation money that sits in the hands of the public and putting them into deposits. For this, they pay interest on deposits. The deposited money has then been locked away and is not used for a pre-determined period in the agreement. As that money can't be used for making payments, it is not counted as part of the money supply in the economy. The Fed influences the interest that banks pay on deposits. The higher the interest rate they pay on deposits, the more individuals will be incentivized to put their money into deposits and therefore out of circulation, reducing the money supply.

Another important thing about banks and money supply is the process of money creation. When you deposit money in a bank, the bank keeps a portion of that money in their reserves to make sure they have enough money to give back to clients in case of withdrawal demands and use the rest of the money to make loans to other clients.

Let's assume that the client who borrowed from Bank 1 is named Lucy. Lucy then uses these borrowed funds and buys an iPhone from Bob. Bob uses the money he got from selling his iPhone to deposit them in another bank - Bank 2.

Bank 2 uses the deposited funds to make loans while keeping a portion of them in their reserves. This way, the banking system has created more money in the economy from the money Bob had deposited, thus increasing the money supply.

To learn about money creation in action, check our explanation on the Money Multiplier.

The portion of the funds that banks are required to keep in their reserves is determined by the Federal Reserve. Usually, the lower the amount of funds banks have to keep in their reserve, the higher the money supply in the economy is.

Money Supply Curve

What does the money supply curve look like? Let's take a look at Figure 2 below, showing the money supply curve. Notice that the money supply curve is a perfectly inelastic curve, which means that it is independent of the interest rate in the economy. That is because the Fed controls the amount of money supply in the economy. Only when there’s a change in the Fed's policy the money supply curve can shift either to the right or the left.

Figure 2. Money supply curve - StudySmarter Originals

Another important thing to notice here is that the interest rate is not solely dependent on the money supply but rather on the interaction of the money supply and the money demand. Holding money demand constant, changing the money supply will also change the equilibrium interest rate.

To better understand the changes in the equilibrium interest rate and how money demand and money supply interact in an economy, check our explanation - the Money Market.

The money supply curve represents the relationship between the quantity of money supplied in the economy and the interest rate.

The Federal Reserve controls the money supply, and there are three main tools it uses to cause a shift in the money supply curve. These tools include reserve requirement ratio, open market operations, and discount rate.

Figure 3. A shift in the money supply - StudySmarter Originals

Figure 3 shows a shift in the money supply curve. Holding money demand constant, a shift in the money supply curve to the right causes the equilibrium interest rate to drop and increases the amount of money in the economy. On the other hand, if the money supply shifted to the left, there would be less money in the economy, and the interest rate would rise.

To learn more about the factors that would cause the money demand curve to shift, see our article - Money Demand Curve

Money Supply: Reserve Requirement Ratio

The reserve requirement ratio refers to the funds that banks are obliged to keep in their reserves. When the Fed lowers the reserve requirement, banks have more money to lend to their clients as they need to keep less in their reserves. This then shifts the money supply curve to the right. On the other hand, when the Fed maintains a high reserve requirement, banks are obliged to keep more of their money in reserves, preventing them from making as many loans as they otherwise could. This shifts the money supply curve to the left.

Money Supply: Open Market Operations

Open market operations refer to the Federal Reserve's buying and selling of securities in the market. When the Fed buys securities from the market, more money is released into the economy, causing the money supply curve to shift to the right. On the other hand, when the Fed sells securities in the market, they withdraw the money from the economy, causing a leftward shift in the supply curve.

Money Supply: Discount Rate

The discount rate refers to the interest rate banks pay to the Federal Reserve for borrowing money from them. When the Fed increases the discount rate, it becomes more expensive for banks to borrow from the Fed. This then leads to a decrease in the money supply, which causes the money supply curve to shift to the left. Conversely, when the Fed decreases the discount rate, it becomes relatively cheaper for the banks to borrow money from the Fed. This results in a higher money supply in the economy, causing the money supply curve to shift rightward.

Effects of the Money Supply

Money supply has enormous effects on the U.S. economy. By controlling the money supply that circulates in the economy, the Fed can either increase inflation or keep it under control. Therefore, economists analyze the money supply and develop policies revolving around that analysis, which benefit the economy. It is necessary to conduct public and private sector studies to determine if the money supply influences price levels, inflation, or the economic cycle. When there is an economic cycle characterized by a rise in the price levels, such as the one we are experiencing currently in 2022, the Fed needs to step in and influence the money supply by controlling the interest rate.

When the quantity of money in the economy increases, interest rates tend to fall. This, in turn, leads to greater investment and more money in the hands of consumers, resulting in a boost in consumer spending. Businesses react by boosting their orders for raw materials and expanding their output. The higher level of commercial activity leads to a rise in the demand for workers.

On the other hand, when the money supply shrinks or when the pace of expansion of the money supply slows, there will be less employment, less output produced, and lower wages. That is due to the lower amount of money flowing into the economy, which could boost consumer spending and encourage businesses to produce more and hire more.

Changes in the money supply have long been recognized to be a significant determinant in the direction of macroeconomic performance and business cycles, and other economic indicators.

To better understand the positive effects of the money supply, let us consider what happened during and after the 2008 Financial Crisis. During this period, there was a decline in the US economy, the sharpest decline since the Great Depression. Hence, some economists call it the Great Recession. During this period, many people lost their jobs. Businesses were shutting down as consumer spending dropped by a significant level. Housing prices were also collapsing, and the demand for houses was sharply down, resulting in significantly depressed aggregate demand and supply levels in the economy.

To tackle the recession, the Fed decided to increase the money supply in the economy. A few years later, consumer spending went up, which boosted the aggregate demand in the economy. As a result, businesses employed more people, producing more output, and the US economy got back on its feet.

Money Supply - Key takeaways

• The Money Supply is the sum of checkable or near checkable bank deposits plus currency in circulation.
• Money supply curve represents the relationship between the quantity of money supplied in the economy and the interest rate.
• By controlling the money supply circulating in the economy, the Fed can either increase inflation or keep it under control. Banks play an essential role when it comes to the money supply. An important distinction is that the Fed acts as a regulator while the banks carry out the regulations.
• When the money supply shrinks or when the pace of expansion of the money supply slows, there will be less employment, less output produced, and lower wages.
• There are three main tools that the Fed uses to cause a shift in the money supply curve. These are the reserve requirement ratio, open market operations, and discount rate.

The money supply is defined as the total amount of currency and other liquid assets circulating in a country's economy when the money supply is measured. 

Money supply has enormous effects on the US economy. By controlling the money supply that circulates in the economy, the Fed can either increase inflation or keep it under control.

When the money supply shrinks or when the pace of expansion of the money supply slows, there will be less employment, less output produced, and lower wages.

Examples of money supply include the amount of currency that circulates in the US economy. Other examples of money supply include checkable bank deposits.

The Fed controls the money supply, and there are three main tools that the Fed uses to cause a shift in the money supply curve. These tools include reserve requirement ratio, open market operations, and discount rate.

Question

The Monetary Base is the sum of currency in circulation plus the ________ held by banks 

Answer

Question

Which of the following is NOT part of the Money Supply?

Answer

Question

The money multiplier is the ratio of:

Answer

The Money Supply to the Monetary Base.

Question

The Money Multiplier tells us the total number of dollars created in the banking system by each $1 increase to the ________ ____. 

Answer

Question

The _______ _____ is the minimum ratio or percentage of deposits that a bank is required to keep in its reserves as cash.

Answer

Question

The Money Multiplier can be calculated as the inverse of the _______ _____.

Answer

Question

If the reserve ratio is 20%, then the money multiplier equals?

Question

A country could use the Reserve Ratio to increase which of the following:

Answer

Question

What does a change in the Money Supply not affect?

Answer

Question

Which one of the following factors would NOT have an effect on the Money Multiplier?

Answer

Question

if a country increases the reserve ratio, banks will be forced to reduce their lending, leading to a fall in the _____ ______.

Answer

Question

If the money multiplier is 50, the reserve ratio must be:

Answer

Question

What is not required to calculate the money multiplier?

Answer

Question

When a bank holds reserves greater than that required by the Reserve Ratio, that's called ______ ________.

Answer

Question

A bank would hold excess reserves to protect themselves from:

Answer

Question

Answer

The money supply is defined as the total amount of currency and other liquid assets circulating in a country's economy when the money supply is measured. 

Question

What is the importance of money supply?

Answer

Money supply has enormous effects on the US economy. By controlling the money supply that circulates in the economy, the Fed can either increase inflation or keep it under control.

Question

What are the negative effects of money supply?

Answer

When the money supply shrinks or when the pace of expansion of the money supply slows, there will be less employment, less output produced, and lower wages.

Question

What is an example of money supply?

Answer

Examples of money supply include the amount of currency that circulates in the US economy. Other examples of money supply include checkable bank deposits.

Question

What are the three shifters of the money supply?

Answer

The Fed controls the money supply, and there are three main tools that the Fed can use to cause a shift in the money supply curve. These tools include: reserve requirement ratio, open market operations, and discount rate.

Question

What is the difference between the Fed and other banks when it comes to the role they play in the money supply?

Answer

The Fed acts as a regulator while the banks carry out the regulations. In other words, the Fed's decision impacts banks, thereby impacting the money supply in an economy. 

Question

What are the two ways banks influence the money supply?

Answer

Banks influence the money supply by taking out of circulation money that sits in the hands of the public and putting them into deposits.
Banks influence the money supply through the process of money creation.

Question

Why is the money supply curve perfectly inelastic?

Answer

Because the Fed controls the amount of money supply in the economy. 

Question

What does it mean for the money supply to be perfectly inelastic?

Answer

It means that the money supply is independent of the interest rate in the economy. 

Question

Explain how the reserve requirement ratio affects the money supply?

Answer

When the Fed lowers the reserve requirement, banks have more money to lend to their clients as they need to keep less in their reserves; this then shifts the money supply curve to the right.

On the other hand, when the Fed keeps a high reserve requirement, banks should keep more of their money in reserves, preventing them from making as many loans as they previously could. This shifts the money supply curve to the left.

Question

What is the reserve requirement ratio?

Answer

The reserve requirement ratio refers to the funds that banks are obliged to keep in their reserves.

Question

Explain how the Fed can use open market operations to control the money supply?

Answer

When the Fed buys securities from the market, more money is going to the market, causing the money supply curve to shift to the right.

On the other hand, when the Fed sells securities in the market, they are effectively withdrawing money from the market, causing a shift in the supply curve to the left.

Question

Explain how the Fed uses the discount rate to control the money supply?

Answer

When the Fed increases the discount rate, it becomes more expensive for banks to borrow from them. This then leads to a decrease in the money supply, which causes the money supply curve to shift to the left.

On the other hand, when the Fed decreases the discount rate, it becomes cheaper for the banks to borrow money from the Fed. This results in a higher money supply in the economy, causing the money supply curve to shift to the right.

Question

What happens in the economy when there is an increase in the money supply?

Answer

When the quantity of money increases, interest rates tend to fall, as there is more money in the market, and you don't have to pay a higher price to access it. This, in turn, leads to greater investment and more money in the hands of consumers, resulting in a boost in consumer spending. Businesses react by boosting their orders for raw materials and expanding their output. The higher level of commercial activity leads to a rise in the demand for workers. 

Question

What action would the Fed take when there is an increase in inflation?

Answer

The Fed would reduce the money supply in the economy to control inflation.

Question

Answer

Money creation is a process where a bank uses a part of its customers’ deposits to offer loans to other individuals and businesses. This results in more money created in an economy.

Question

Why bank deposits are one of the most common types of money?

Answer

Most of the time these bank deposits are used to make fund transfers from one account to the other. This makes them one of the most common forms of money

Question

What does the money creation theory state?

Answer

The money creation theory states that under a system where banks are required to keep only a relatively small portion of their money in reserves, an initial deposit creates more money than initially deposited.

Question

How banks create new purchasing power?

Answer

As a result of their lending activities, banks produce deposits which then create new purchasing power.

Question

What enables bank to create money?

Answer

The capacity of banks to issue credit monthly is partly a result of their exemption from the ‘client money rules’.  

Question

Can stockbrokers create money?

Answer

No because non-bank organisations such as stockbrokers are required to keep clients' money separate from the non-bank organisation's assets and liabilities on their balance sheet, which is also what prevents them from creating credit money.

Question

What limits the capacity of banks to create money?

Answer

Banks' capacity to create money is limited by their need to maintain an adequate gap between the interest rate obtained on money lent and the cost of bank capital.

Question

What does rapid growth in bank lending mean for the profitability of a bank?

Answer

Rapid growth in bank lending would require a reduction in the interest rate offered to borrowers, lowering bank profitability. 

Question

How to calculate how much money is created by a single deposit?

Answer

You can calculate how much money is created by a deposit using the money multiplier.

Question

Assume the Fed required all the banks to keep a ratio of 10% in their reserves. How much money creation would take place if one person deposited $500 in JP Morgan Chase? 

Answer

Total credit creation = 500/0.1 = 5000. This means that the total credit creation of money is $5000. 

Money multiplier = 1/0.1 = 10. This means that for every $1 deposited, $10 is generated in the economy through credit creation.

Question

What are the limitations of money creation?

Answer

The limitations of money creation include the amount of cash in the deposits, the reserve ratio, and default risk. 

Question

Explain how the amount of cash in the deposits limits money creation.

Answer

The number of cash deposited in a bank hugely affects the money supply in an economy. If the public decided to deposit more money in the bank than usual the bank would end up generating more money. On the other hand, a bank could create less money if there were fewer deposits. This makes the amount of cash deposit a significant limitation to a bank's money creation.

Question

Explain how the reserve ratio limits money creation.

Answer

This is also known as the required reserve ratio and it refers to the portion of deposits a bank is required to keep in its reserves to meet withdrawal requests. This is set by the Fed and it also serves as a tool to keep track of the money supply in the economy. The lower the reserve ratio, the higher the money supply. 

Question

Explain how default risk limits money creation.

Answer

Banks may face limitations in the amount of money they can create as they might need to select which customers they lend to. The reason for that could be that banks don't want to make a loan to someone incapable of paying back or might have an increased risk of default. A default would cause huge losses for banks as they would also have to meet the liability of the depositors.

Question

What is money supply measurement?

Answer

Measuring the money supply means calculating the total stock of money in the economy at a particular time.

Question

Why is measuring money supply important?

Answer

Not knowing the current money supply places the economy at risk of inflation (too much money) or recession (too little money).

Question

What is the advantage of measuring the supply money?

Answer

Knowing the current money supply lets the government adjust it through monetary policy. If the money supply is too low to sustain healthy growth, which puts the economy at risk of recession, the Fed can use monetary policy to increase it.

Question

How is money supply measured?

Answer

Methods used to measure the money supply include M0, M1, and M2.

Question

What are the most common money supply measurements?

Answer

Question

What is the purpose of measuring the money supply?

Answer

One goal of economists and those in the finance (banking and lending) industry is to accurately measure the money supply to determine economic health and potential economic growth rates.