Hi! Thanks for a very interesting question.
Before we start, let us examine what the money supply consists of.
The money supply isn’t just made of the cash in our pockets (it is
called M1 in Financial and banking sectors) but other types of liquid
accounts and investments as well.
“Currency and cash are the purest forms of money and are included in
all measures of the supply. Also included in the narrow measures of
money (such as M1) is the amount of money in checking accounts. Ever
broader measures (M2, MZM, and M3) add on money market funds, CDs,
very large savings accounts, and so on.”
Knowing this we can now answer how the fluctuation of money supply
affects the economy, each of the different types of money will have a
role to play.
“It may be intuitive to suppose that the money supply grows when the
government prints currency. But in fact any money held in a bank or
Federal Reserve vault that isn't in a customer's name is not included
in money supply. So when currency is printed, it doesn't get added to
the money supply until it's needed.”
“If too much money enters the system too fast, you get inflation. This
is because an increase in money relative to a fixed number of
consumable goods and services, results in rising prices.”
“Conversely, the effect of a shrinking money supply is to choke off
the stimulus necessary to keep an economy expanding. The Fed tries to
allow for enough money growth to sustain economic prosperity, but not
so much as to cultivate inflation.”
The article goes on to say that the FED controls the money supply
through reserve requirements in banks, buying and selling of treasury
notes and through changing interest rates.
“Money Supply for Dummies”
http://www.quicken.com/cms/viewers/article/investments/5271
THE FED however in statements by it’s popular chairman, Alan
Greenspan, says that the effects of the money supply, in its different
forms, to the economy has slowly been declining but it is still a
good measure of the economy.
“…in 1981, however, the relationship between M1 growth and measures of
economic activity, such as Gross Domestic Product, broke down.”
“By the early 1990s, the relationship between M2 growth and the
performance of the economy also had weakened. Interest rates were at
the lowest levels in more than three decades, prompting some savers to
move funds out of the savings and time deposits that are part of M2
into stock and bond mutual funds, which are not included in any of the
money supply measures.”
“However, the Fed said, too, that ‘…the FOMC believes that the
behavior of money and credit will continue to have value for gauging
economic and financial conditions.’ Moreover, M2, adjusted for changes
in the price level, remains a component of the Index of Leading
Economic Indicators, which some market analysts use to forecast
economic recessions and recoveries.”
“The Money Supply”
http://www.ny.frb.org/pihome/fedpoint/fed49.html
Search terms used:
Economy "money supply"
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Regards,
Easterangel-ga
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