definition of money supply

Money and Banking – Cambridge IGCSE/A‑Level (9708) – Topic 9.4

Objective

Define the money supply, explain why it matters, and master the related macro‑economic concepts required for the Cambridge syllabus (AO1‑AO3).

1. Money – Definition & Functions

Money is any item or record that is widely accepted as a means of payment for goods and services and for the discharge of debts. It performs four essential functions:

• Medium of exchange – allows transactions without barter (e.g., using a £10 note to buy a bus ticket).
• Unit of account – provides a common measure for pricing and accounting (prices are quoted in pounds).
• Store of value – preserves purchasing power over time, provided inflation is low (e.g., saving £100 for future use).
• Standard of deferred payment – enables borrowing and lending; future payments are expressed in monetary terms (e.g., a mortgage).

These functions explain why economists monitor the quantity of money in an economy.

2. Characteristics of Money (and Why They Matter)

3. Money Supply – Formal Definition

The money supply (M) is the total stock of monetary assets that are available for use in the economy at a particular point in time. It includes cash (the most liquid form) and assets that can be readily converted into cash.

Formal definition (LaTeX):

$$M = \sum_{i=0}^{n} M_i$$

where M_i denotes each monetary aggregate (M₀, M₁, M₂, M₃…) and n is the highest aggregate reported by the central bank. Stating that M₀‑M₃ are “monetary aggregates” links the definition directly to the next sub‑point.

4. Monetary Aggregates – Liquidity Hierarchy

Not all countries publish M₃; the syllabus only requires knowledge of M₀‑M₂.

5. The Money‑Market Diagram & the LM Curve

• M_s – vertical (perfectly inelastic) because the central bank fixes the quantity of money at a given point.
• M_d – downward‑sloping; higher interest rates raise the opportunity cost of holding money, so people hold less.

Equilibrium where M_s = M_d determines the market interest rate (i). Combining this equilibrium with the goods‑market equilibrium (IS curve) yields the LM curve, which shows all (Y, i) combinations that equilibrate both markets.

Classroom activity: Sketch a labelled money‑market diagram, then transform it into an LM curve on an (Y, i) graph.

6. Quantity Theory of Money

$$MV = PT$$

• M = money supply
• V = velocity of money (average number of times a unit of money is spent per period)
• P = price level
• T = real volume of transactions (or real output, Y)

Assumptions for the A‑Level version:

• V is constant in the short run.
• T (or Y) grows at a steady rate.

Implication: if V and Y are unchanged, a proportional increase in M leads to a proportional increase in P (inflation).

7. Commercial Banks & Money Creation

1. Deposit – a customer places cash in a bank.
2. Reserve requirement (rr) – the central bank mandates that banks keep a fraction of deposits as reserves.
3. Loan creation – banks lend out the remaining proportion, creating a new deposit in the borrowing bank’s balance sheet.
4. Money multiplier – the total potential increase in the money supply is
   $$\text{Money Multiplier} = \frac{1}{rr}$$

Example: If rr = 10 % (0.10), the multiplier is 10. An initial deposit of £1 million could ultimately support up to £10 million of broad money (M₂) in the economy, assuming no excess reserves and no cash leakage.

8. Monetary‑Policy Tools (Cambridge syllabus)

9. Measuring the Money Supply (How the Aggregates are Compiled)

1. Obtain data on physical currency in circulation from the central bank’s statistical releases.
2. Collect commercial‑bank balance‑sheet information on demand, savings, and time deposits.
3. Classify each deposit according to its liquidity (checkable, savings, large‑time, etc.).
4. Sum the classified components to produce the values for M₀, M₁, M₂ and, where reported, M₃.
5. Adjust for any cash held by the public (currency outside banks) when moving from M₀ to M₁.

10. Why the Money‑Supply Definition Matters (AO3 – evaluation)

• Monetary policy operates by influencing the quantity of money, which in turn affects interest rates, inflation, exchange rates and overall economic activity.
• Accurate measurement of the aggregates is essential for forecasting, evaluating policy outcomes, and answering data‑response questions in the exam.
• Understanding the definition helps students assess the limits of policy (e.g., when the money multiplier is reduced by high excess reserves).

11. Suggested Revision Diagrams

• Money‑market diagram (M_s vs. M_d) with equilibrium interest rate.
• LM curve derived from the money‑market equilibrium.
• Quantity‑theory flow diagram showing the relationship between M, V, P and Y.
• Fractional‑reserve money‑creation flowchart (deposit → reserves → loans → new deposits).

12. Quick‑Check Questions (AO1‑AO3)

1. List the four functions of money and give a short example of each.
2. Explain how a change in the reserve‑requirement ratio affects the money multiplier and the potential size of the money supply.
3. Using the equation MV = PT, describe what would happen to the price level if the money supply doubles while V and T remain unchanged.
4. Sketch a labelled money‑market diagram and indicate the effect on the equilibrium interest rate when the central bank conducts an open‑market purchase of securities.
5. Discuss one advantage and one limitation of using M₂ as the main indicator of “broad money” for monetary‑policy decisions.