What is the relationship between money supply and GDP?

Money supply refers to all currencies and other liquid instruments in a country’s economy. A country’s money supply includes both cash and other types of deposits that can be used almost as easily as cash. The US Federal Reserve has been releasing money supply data for many decades because of the effects money supply is believed to have on real economic activity and price levels.

Measures of money supply data released by the Federal Reserve on a weekly and monthly basis are called M1 and M2. To measure money supply, most economists use the Federal Reserve’s M1 and M2 measures. Data on the Federal Reserve’s money supply is released in reports available at 4:30 p.m. every Thursday. These reports appear in select Friday newspapers and are also available online.

Key points to remember

  • Money supply refers to all currencies and other liquid instruments in a country’s economy.
  • Gross domestic product (GDP) is a measure of the total value of all finished goods and services produced within a country’s borders during a specified period of time.
  • Nominal GDP – GDP calculated at current market prices – tends to increase with the money supply, but this is not always the case.
  • The US Federal Reserve has been releasing money supply data for many decades because of the effects money supply is believed to have on real economic activity and price levels.
  • Over the past several decades, research has shown that the relationship between money supply growth and the performance of the US economy is weakening.

Another measure typically released by a country’s government is gross domestic product (GDP). GDP is a measure of the total value of all finished goods and services produced within a country’s borders during a given period. GDP is generally assessed as a comprehensive indicator of the overall economic health of a country. In the United States, the government publishes data on the country’s GDP on an annual and quarterly basis.

Nominal GDP refers to GDP calculated at current market prices. Nominal GDP tends to increase with the money supply, but this is not always the case. Real GDP, also known as “constant price,” “inflation-adjusted” or “constant dollar GDP,” is an inflation-adjusted measure of a country’s GDP. Real GDP does not have such a clear relationship with money supply Real GDP tends to be influenced more by the productivity of economic agents and firms.

The relationship between money supply and GDP also depends on whether you take a short or long term view of the economy.

How money supply affects gross domestic product

According to many theories of macroeconomics, an increase in the money supply should lower interest rates in the economy. An increase in the money supply means that more money is available for borrowing in the economy. This increase in supply, in accordance with the law of demand, tends to lower the price of the loan. When it is easier to borrow money, consumption and credit (and borrowing) rates both tend to rise. In the short run, higher rates of consumption, lending and borrowing can be correlated with an increase in an economy’s total output and expenditure and, presumably, in a country’s GDP. While this outcome is expected (and predicted by economists), it is not always the actual outcome.

The long-term impact of an increase in the money supply is more difficult to predict. Throughout history, the prices of assets, such as housing and stocks, have had a strong tendency to increase artificially as a result of an increase in the money supply or whatever causes a high level of money. liquidity entering the economy. This misallocation of capital can lead to waste and speculative investment, which can result in a rapid escalation in asset prices followed by a contraction (an economic cycle called a bubble) or an economic recession, a significant downturn. of economic activity.

On the other hand, if prices are not badly distributed and asset prices do not inflate artificially, it is possible that in the long run the only impact of an increase in the money supply is higher prices. than those consumers would normally have had to deal with.

Relationship between GDP and money supply

While a country’s GDP is not a perfect representation of economic productivity and health, in general, a higher level of GDP is more desirable than a lower level. A country’s GDP provides information about the size of its economy, and the rate of GDP growth is one of the best indicators of economic growth over time. The measurement of GDP per capita is also closely correlated with changes in the standard of living over time.

In general, when the growth rate of GDP shows an increase in economic productivity, the value of currency in circulation increases. This is because each monetary unit can then be exchanged for goods and services of greater value.

Economic growth tends to have a natural deflationary effect, even if the money supply is not shrinking. Some evidence of this phenomenon can be seen in the tech sector, where innovations and technological advancements grow faster than inflation; currently, the prices of televisions, cell phones and computers tend to fall.

Monetary Policy

There are many reasons why a country’s money supply can increase. Central banks of countries can print more money. Banks may choose to reduce their liquidity ratio and therefore be willing to lend more of their funds to consumers and businesses. There may also be an influx of funds from abroad if a central bank buys its currency on the foreign exchange markets in order to build up its foreign exchange reserves. The government can also increase the money supply through its activities, mainly by purchasing government securities. When the government buys bonds from investors, the people who held them have more money to spend.

Any action by central banks to increase or decrease the money supply is referred to broadly as monetary policy. The US Federal Reserve pursues three broad macroeconomic objectives: price stability, sustainable economic growth and a high employment rate. Historically, the US Federal Reserve has attempted many different policies to influence the size of the money supply in order to achieve these macroeconomic goals. However, in recent decades, research has shown that the relationship between money supply growth and the performance of the US economy is weakening. As a result, the emphasis on using the money supply as the primary vehicle for monetary policy has diminished.

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