Sunday, June 10, 2012

Standard measurements of Money Supply

According to the IMF’s manual, money supply is measured as the combined deposit liabilities of the banking system and the currency liabilities of the central bank, both held by households, firms, nonprofit institutions and all public sector entities outside of the central government. In this official or standard representation of money supply, there are three monetary aggregates delineated; M0, M1 and M2.

M0 includes only currency in the hands of the public, banks’ statutory reserve deposits held at the central bank and banks’ cash reserves. This aggregate represents the monetary liabilities of the central bank and is usually referred to as the monetary base or reserve money.

The second aggregate M1, comprises currency held outside the banking system and the current account deposit liabilities of commercial banks held for transactive purposes.3 It may also include some foreign currency deposits that are used for domestic transactions. This definition implies that only assets that are directly used in making payments should be considered as money. It should be noted that although most current account deposits do not attract interest, they provide a convenient and safe alternative to cash as a means of payment.

The M2 aggregation of money supply seeks to broaden the range of liquid assets to include some interest earning items, such as savings deposits and fixed or time deposits. This broad monetary aggregate, M2, comprises M1 plus short-term (usually a year and under) savings and time deposits, certificates of deposit, foreign currency transferable deposits and repurchase agreements. Although some of these assets are not readily accepted as payment for goods and services, the transaction cost associated with their conversion is relatively small. For example, with the introduction of automated banking machines, holders of savings accounts no longer have to go directly to the bank to make withdrawals thus the burden of converting savings balances to cash is minimised. As such, savings accounts are now used in a similar manner as current accounts in many societies, thereby enhancing depositors’ capacity and convenience in undertaking expenditure. With respect to time deposits, since these deposits can be withdrawn on short notice, they also provide some degree of liquidity to depositors. It should also be noted that there is an interest penalty associated with the pre-mature closure of these accounts. However, as long as the benefit of breaking these arrangements outweighs the cost, they do represent an alternative to cash and current accounts.

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