The Money Supply & Quantity Theory of Money (Cambridge (CIE) A Level Economics): Revision Note

The money supply

• The money supply is the total stock of money in circulation in an economy at a given point in time.

  • The money supply includes all financial assets that function as money, ranging from the most liquid (cash) to less liquid forms

  • Its main components are

    • Cash in circulation - notes and coins held by the public

    • Demand deposits - funds held in current accounts that account holders can withdraw at any time without prior notice

    • Near money - savings deposits, money market funds, and other financial assets that are highly liquid and readily convertible into cash but are not immediately used for transactions

The distinction between narrow and broad money

Narrow money

• Narrow money is the most liquid part of the money supply - cash in circulation plus demand deposits at banks that can be used immediately for transactions

  • Its primary role is to function as a medium of exchange

  • Narrow money is what consumers and firms use to settle day-to-day transactions

Broad money

• Broad money includes narrow money plus less liquid financial assets that still function as stores of value, such as savings deposits, time deposits, and money market funds

  • These assets are not immediately available for transactions but can be converted into cash with some delay

  • Broad money gives a wider picture of purchasing power in the economy

Liquidity

• Liquidity measures the ease with which an asset can be converted into cash without significant loss of value

  • Cash is the most liquid asset

  • Savings deposits are less liquid than demand deposits - they may require notice of withdrawal

• Shares and property are financial and real assets respectively - they are not part of the money supply, even though they can be converted into cash

The quantity theory of money

• The quantity theory of money (QTM) states that the general price level in an economy is proportional to the money supply, assuming the velocity of circulation and the volume of transactions are constant.

  • The QTM is central to the monetarist school of economic thought, most closely associated with Milton Friedman

  • Monetarists argue that central banks should focus on controlling the money supply to achieve price stability, and that steady, predictable money supply growth contributes to stable economic conditions

The quantity theory of money equation

MV = PT

• MV represents total spending in the economy

• PT represents the total nominal value of goods and services exchanged

• The theory rests on two key assumptions

  • Velocity (V) is stable in the short run, determined by institutional factors (payment habits, banking technology)

  • The total number of transactions (T) is constant at full employment, determined by real productive capacity

• Under these assumptions, a change in the money supply (M) must cause a proportional change in the general price level ( P)

• An x% increase in the money supply therefore causes an x% increase in the price level, leading to inflation

Limitations of this theory

• V is not always stable

  • It varies with interest rates, consumer confidence and financial innovation

• T is not always constant

  • Economies often operate below full employment, so an increase in M can raise output rather than prices

• Keynesians argue that because velocity (V) and total number of transactions (T) both respond to changes in the money supply (M), the QTM's prediction does not hold reliably in practice