Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Controlling the supply of some types of money

The analysis that we present in the preceding sections assumes that the central bank has full control over the money supply, but this helpful simplification isn’t entirely true. The central bank has control over only some of the different types of money. Everyone agrees that notes and coins are forms of money, but does your bank balance count as money? Does it make a

difference if it’s in a savings account or a current account? If you write a cheque, is that money? Are your credit or debit cards as good as money? When you start thinking about this issue, what precisely counts as money isn’t at all clear.


For this reason, different measures and categories exist regarding how much money is in an economy. The first three measures are sometimes called narrow money, because they’re quite restricted in terms of what counts as money:


Notes and coins: Simply the notes and coins in circulation.


M0 (or the monetary base): Includes notes and coins but also commercial banks’ claims on the central bank. In a modern economy, when you transfer money to your friend, your bank doesn’t send over a wad of cash to your friend’s bank. Instead, commercial banks use an electronic payment system managed by the central bank. Think of it as each bank having a bank account with the central bank. The monetary base includes all this ‘electronic money’ held with the central bank.


M1: Includes notes and coins but also demand deposits, ones held by individuals or firms in accounts that allow funds to be withdrawn at any time without notice. The idea behind this measure is that, to an average person, money held in an account that can be used to make immediate purchases, for example using a debit card, is as good as cash.

The next three measures are more liberal about what counts as money, and so are sometimes called broad money:

M2: Includes the items in M1 but also savings deposits and small time deposits held by people. The money held in these accounts typically pays interest, and depositors may incur penalties if they want to access their funds at short notice.

M3: Includes the items in M2, but also large time deposits and some money market funds. These large funds combine savings from many different individuals and try to get a good return without taking on (much) risk.

M4: Even broader than M3, you get the idea… !


Although the central bank has a good amount of control over narrow measures of money, it has not much control over broad measures of money. For this reason central banks have to use a number of different strategies in order to change the interest rate:


Open market operations: Buying and selling bonds to affect the supply of money and the yield on government bonds (see the preceding section).


Allowing commercial banks to borrow from the central bank at a


certain rate: Usually very short-term loans (overnight). The idea is that making it cheaper (or more expensive) for banks to borrow from the central bank impacts the rates at which banks are willing to lend money.


Allowing banks to deposit excess reserves at the central bank and