3. Money Supply
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- What is Money Supply?
- Money Supply is simply the amount of money in circulation at a given time. It is the entire quantity of bills, coins, loans, credit, and other liquid instruments in a country's economy.
Over the centuries money has taken various forms, everything from shells and stones to the paper and coins we use today. Historically, the most stable periods of economic activity have existed when money was backed by a store of value, usually gold (often referred to as the “Gold Standard”). In fact, gold is recognised as such an excellent store of value that it has underpinned the world's monetary system in one way or another for thousands of years.
Britain first moved to a gold standard in 1717 when the value of the pound was translated into gold at 3 pounds, 17 shillings, 10.5 pence per ounce of gold. This standard persisted for more than 200 years, interrupted only by wars and one or two other major crises. More recently, towards the end of the Second World War, the Bretton Woods Agreement was signed in which 44 major nations agreed to fix their currencies at a certain price against a certain quantity of gold.
- The Creation of Credit
- Once within the banking system the gold deposits could be re-lent. Paper money circulated as currency, with each paper note being backed by a fixed amount of gold. Banks were able to create credit by lending out more paper money than the amount of gold placed with them, but always sought to ensure that they had enough gold in their reserves to meet the demand for withdrawals from their customers. As a result banks adopted a conservative approach, not lending out too high a multiple of their reserves for fear of going insolvent.
The creation of credit allowed individuals and companies to borrow money, facilitating private and corporate investment and economic expansion. As companies expanded, jobs were created and the appetite of the consumer grew. This led to the purchase of more goods and services, boosting corporate profitability further in a virtuous circle of growth and prosperity.
Gold played a vital role in this respect, ensuring that the economy of a particular country did not overheat and that the country’s economic relationship with other countries remained stable.
- An Example
- It can be seen from the above that both countries exist in economic equilibrium. Balance is maintained by the flow of a finite amount of gold between them, resulting in a cyclical pattern of expansion and contraction depending on whether gold was flowing into or out of the country respectively. It is this balance which helped to prevent economic excess and economic overheating.
But here’s where the story get interesting. Over the last 30 years we haven’t seen much equilibrium. We have seen amplified market cycles which have resulted in asset price booms and spectacular market crashes. What happened?