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Factors Affecting Money Supply- 10 Major Factors Explained in Detail | Macroeconomics

Factors Affecting Money Supply 

A country’s money supply can be described as the total amount of money available at a particular time in its economy. Among the types of money are cash, coins, check deposits, and savings accounts. People can borrow money at different interest rates depending on the money supply, which influences economic activity, inflation, and interest rates.

Most countries’ central banks, such as the Federal Reserve in the United States, measure the money supply. In order to increase or decrease the money supply, the central bank can buy or sell government securities.

The following are the various factors that affect the supply of money in the economy:

Factors Affecting Money Supply 

1) Volume of Transactions

Volume of Transactions

Inflationary pressures are created in the economy if the currency is issued more than what is required. On the other hand, deflationary pressure is created if the money supply or currency issuance is less than what is required.

The money supply can increase when the volume of transactions increases. Because more money is being exchanged and used in transactions, the amount of money in circulation can increase as a result. The money supply can also decrease when the volume of transactions decreases. The volume of transactions can also affect the money supply in the following ways:

  • It is possible for money demand to increase as the volume of transactions increases. Economic transactions are becoming more prevalent, and money is needed to facilitate them.
  • Banks and other financial institutions may lend more money or increase the amount of money they have on hand in response to the increased demand for money.
  • An increase in the supply of money can lead to an increase in the economy’s money supply.
  • On the other hand, as transaction volumes decrease, so does money demand. By reducing their lending and holding more cash, banks and financial institutions can decrease the supply of money.
  • If the money supply decreases, the overall money supply in the economy will decrease as well.
  • The money supply is affected by many factors, not just the volume of transactions. The level of economic activity, changes in interest rates, and government monetary policy are other factors.

2) Nature of Trade

Nature of Trade

Depending upon the nature of business and trade the supply of money in the economy also varies. For example, wholesalers require currency with higher denominations whereas retailers require currency with lower denominations to conduct smooth trade.

Trade has a number of effects on the money supply. A country will receive a net inflow of foreign currency if it exports more goods and services than it imports. As a result, the country’s domestic currency supply will increase, increasing the money supply. A country will lose foreign currency if it imports more goods and services than it exports. As a result, the domestic currency supply can decrease, thereby reducing the money supply.

Money supply can also be affected by the terms of trade. A country’s currency supply may increase if it exports goods and services at higher prices, which will result in more foreign currency.

Alternatively, lower prices for exports can result in less foreign currency being received, thereby decreasing the money supply for a country. A country’s money supply is affected by the rate at which foreign currency flows in and out due to the nature of trade.

3) Method of Payment

Method of Payment

There is a high requirement for money supply in the economy if most of the payments are conducted via cash but in case if the payments are made via cheque then there is a low requirement for the money supply.

Liquidity in the economy is also affected by the method of payment, which is the ability to convert assets into cash quickly. Liquidity refers to the ability to convert assets into cash, which increases the money supply when there is a high level of liquidity.

Liquidity, on the other hand, signifies how easily assets can be converted into cash, thereby reducing the supply of money. The method of payment affects the rate of financial transactions, the level of liquidity in the economy, and the speed of the money supply.

4) The Price Level

The Price Level

There is a high requirement for currency if the price level is high. Likewise, there is a low requirement for currency if the price level is low. A country’s price level is a measure of the price of goods and services on average. In order to purchase the same goods and services, people must pay more money when prices increase.

Central banks may increase the money supply to compensate for decreased purchasing power. Money can be created by lowering interest rates or increasing circulation, for example. Deflation can be prevented by decreasing the money supply if the price level decreases.

5) Banking Habits

Banking Habits

If the public has fewer banking habits then there will be a high requirement for money supply in the economy whereas if the public has good banking habits then there will be a low requirement for money supply in the economy.

An economy’s money supply is directly affected by the banking habits of individuals and businesses. In an economy, banks can lend money to other individuals and businesses when individuals deposit money into their bank accounts. As a result, the money supply in an economy decreases when individuals or businesses withdraw money from their accounts or pay off loans.

The velocity of money within an economy can also be influenced by the banking habits of individuals and businesses. People and businesses may spend less money if they save money or pay off loans rather than spend it, resulting in a slower growth of the money supply as a whole.

6) Distribution of Income

Distribution of Income

Different groups within a society are distributed differently in terms of income distribution. Income distribution can occur among individuals within a household, among demographic groups, or among different regions and countries.

Different factors affect the money supply depending on how income is distributed. As people with more disposable income are more likely to buy goods and services, a more equal distribution of income can increase consumer spending. In turn, higher levels of economic activity can increase money supply as a result of this increased demand for goods and services.

People with lower incomes may not have the disposable income to make purchases as a result of an unequal distribution of income. The money supply can decrease and economic activity can decrease as a result.

In addition, government policies can also affect the money supply through the distribution of income. Income inequality and wealth redistribution can be addressed by government programs such as progressive taxation.

Taxes and government spending can have an impact on the money supply. Income distribution impacts the money supply and can affect the economy’s overall health in significant ways.

7) Volume of Demand deposits

Volume of Demand deposits

Consumers can access their demand deposits immediately and make transactions without having to write checks or use other payment methods. Purchasing and paying bills is possible through these accounts, also known as checking or current accounts.

Demand deposits, which represent the funds available for spending, directly affect the money supply. The money supply increases when demand deposits rise, and vice versa. Economic activity and prices can be affected by changes in the money supply.

If demand deposits increase significantly, consumer spending might increase, which could stimulate the economy. As a result, a decline in demand deposits could cause the economy to slow down and consumer spending to slow down.

Consequently, central banks and other regulators consider the volume of demand deposits when determining monetary policy and trying to manage the money supply. They can promote long-term growth and stability in the economy by controlling money supply.

8) Taxation policy of the government

Taxation policy of the government

A government’s taxation policy can influence the amount of money in circulation, the demand for money, and the level of economic activity, which all contribute to determining the money supply. The money supply can decrease as a result of increased taxation. Increasing taxes reduces the amount of money in circulation because it takes money out of individuals’ and businesses’ hands.

A reduction in taxation, on the other hand, can increase the amount of money available. The government can increase the money supply by reducing taxes, which will result in more spending and investing by individuals and businesses.

The demand for money can also be affected by changes in taxation. High-income earners may decide to hold onto more of their money if the government increases taxes on them, reducing the demand for money.

In addition to reducing taxes on certain sectors and industries, the government can also use its taxation policy to stimulate economic growth. As a result, those sectors could experience an increase in investment and spending, thereby causing the money supply to grow.

9) Public loans

Public loans

Public loans increase the money supply in the economy when the government takes them out. Taking out a loan enables the government to fund projects and expenses in addition to its existing budget. Because of the increase in transactions and economic activity, the money supply in the economy increases.

A poorly managed public loan can, however, have a negative impact on the money supply. Overspending or failing to repay government loans on time can lead to inflation, which can negatively impact the economy and reduce the value of money.

To ensure that the money supply and the overall economy are not negatively impacted, the government should carefully manage its public loans.

10) Volume of deficit financing.

Volume of deficit financing.

By borrowing money from the public or printing new money, the government increases the money supply through deficit financing. When there are more goods and services available than money in circulation, inflation can result. Due to the interest that must be paid back on borrowed money, it can also increase interest rates.

Increasing spending on infrastructure, education, and other projects can also stimulate economic growth through deficit financing. The result can be the creation of jobs and an increase in economic activity.

Governments must carefully consider the trade-offs and use deficit financing wisely when determining the volume of deficit financing.

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