As we said previously, money is the whole of assets generally accepted for payments. But as you may guess, this is not a strictly delimited definition: the border between what is money and what it is not, is somehow blurred. For this reason, usually, to measure the money supply circulation are used different monetary aggregates, which differ on liquidity — the power to be “spent” more or less immediately.
- M0: it is the so-called “monetary base“, the physical currency that is present in the monetary system. This is the most liquid of the monetary aggregates.
- M1: it’s the sum of M0 and at sight deposits. At-sight deposits are deposits immediately payable on request, i.e. the ones when you can immediately withdraw money (checking accounts or current accounts). Checking and current accounts usually also offer a minimum (often nearly zero) interest rate. Saving account can also sometimes be computed in this monetary aggregate.
- M2: the sum of M1 and short-term deposits, i.e. deposit with a duration no longer than two years, that are payable with a maximum three- months notice. Saving accounts are counted here when not considered in M1.
- M3: the sum of M2 and repos, money market funds, debt securities with a maximum two-years duration. This is the broadest measure of money supply.
It’s to be noticed that money supply measure, and thus monetary aggregates definition, are not universal. The definition we gave here is in line with the definitions given by the European Union, that is similar but have some slight difference from money supply measures in the United States.
In some countries the difference may be more notable. For example, in the United Kingdom there are only two official money supply measure, M0 and M4: the first one coincides with M0 definition used by the European Union, while the latter is very similar to M3.
In Italy, before joining the Euro, were used M1, M2 (that was however similar to EU’s M3) and extended M2, that included italian residents deposits in foreign branches of Italian banks. This was meant to help comparing the “territorial” point of view to a “holder” point of view (since this last was the indication of European Community): in other words, measure the money of the country instead of the money in the country.
Why do we need to measure money supply? The reason is quite simple: there is a strong connection between money supply growth and long-term price inflation. This connection can be explained with the fact that money is a medium of exchange, not “something that has value itself”. So if the money supply grows more than the wealth in the system, there is price inflation. Think of slicing a cake: if you increase the number of slices, you get thinner ones, unless you made a bigger cake.
Therefore it is important to control the amount of money in the economic system. Since monetary aggregates are linked by multiplication mechanism, central banks have two main tools to influence money supply:
- Issue paper money (thus altering M0)
- Changing interest rates (that influence the multiplication factor between monetary aggregates)
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