How Does The Real Money Supply Vary With Government Spending As A

Fiscal policy is exogenous. The level of government expenditure and taxation and the tax code set the position of the IS curve. Fiscal policy has no direct effect on the LM curve. Increased government spending or a tax cut is assumed to be ﬁnanced by borrowing. The money supply does not change, so the LM curve does not change.
Since money supply is a supply phenomenon so it doesn’t impact the aggregate demand curve. Aggregate demand curve shifts because of changes in Government spending, interest rate, Net exports and Disposable income. The aggregate demand shifts.
The government cuts public spending but continues to 'run a deficit by borrowing from the central bank.' This is the polite way to say 'increase yearly the money supply by an amount equal to the government's deficit'. So the money supply will also increase in the second year, albeit by a smaller amount than before. But increase it will.

What Is the Money Supply?

Role of money supply. Rise in money supply at constant prices will increase real money supply. It results into the shift of LM curve to the right and thus there will also be rightward shift in the AD curve. Role of government spending. At constant prices & money supply rise in government spending will shift IS curve to the right.

The U.S. money supply comprises currency—dollar bills and coins issued by the Federal Reserve System and the U.S. Treasury—and various kinds of deposits held by the public at commercial banks and other depository institutions such as thrifts and credit unions. On June 30, 2004, the money supply, measured as the sum of currency and checking account deposits, totaled $1,333 billion. Including some types of savings deposits, the money supply totaled $6,275 billion. An even broader measure totaled $9,275 billion.

These measures correspond to three definitions of money that the Federal Reserve uses: M1, a narrow measure of money’s function as a medium of exchange; M2, a broader measure that also reflects money’s function as a store of value; and M3, a still broader measure that covers items that many regard as close substitutes for money.

The definition of money has varied. For centuries, physical commodities, most commonly silver or gold, served as money. Later, when paper money and checkable deposits were introduced, they were convertible into commodity money. The abandonment of convertibility of money into a commodity since August 15, 1971, when President Richard M. Nixon discontinued converting U.S. dollars into gold at $35 per ounce, has made the monies of the United States and other countries into fiat money—money that national monetary authorities have the power to issue without legal constraints.

Why Is the Money Supply Important?

Because money is used in virtually all economic transactions, it has a powerful effect on economic activity. An increase in the supply of money works both through lowering interest rates, which spurs investment, and through putting more money in the hands of consumers, making them feel wealthier, and thus stimulating spending. Business firms respond to increased sales by ordering more raw materials and increasing production. The spread of business activity increases the demand for labor and raises the demand for capital goods. In a buoyant economy, stock market prices rise and firms issue equity and debt. If the money supply continues to expand, prices begin to rise, especially if output growth reaches capacity limits. As the public begins to expect inflation, lenders insist on higher interest rates to offset an expected decline in purchasing power over the life of their loans.

Opposite effects occur when the supply of money falls or when its rate of growth declines. Economic activity declines and either disinflation (reduced inflation) or deflation (falling prices) results.

What Determines the Money Supply?

Federal Reserve policy is the most important determinant of the money supply. The Federal Reserve affects the money supply by affecting its most important component, bank deposits.

Here is how it works. The Federal Reserve requires depository institutions (commercial banks and other financial institutions) to hold as reserves a fraction of specified deposit liabilities. Depository institutions hold these reserves as cash in their vaults or Automatic Teller Machines (ATMs) and as deposits at Federal Reserve banks. In turn, the Federal Reserve controls reserves by lending money to depository institutions and changing the Federal Reserve discount rate on these loans and by open-market operations. The Federal Reserve uses open-market operations to either increase or decrease reserves. To increase reserves, the Federal Reserve buys U.S. Treasury securities by writing a check drawn on itself. The seller of the treasury security deposits the check in a bank, increasing the seller’s deposit. The bank, in turn, deposits the Federal Reserve check at its district Federal Reserve bank, thus increasing its reserves. The opposite sequence occurs when the Federal Reserve sells treasury securities: the purchaser’s deposits fall, and, in turn, the bank’s reserves fall.

If the Federal Reserve increases reserves, a single bank can make loans up to the amount of its excess reserves, creating an equal amount of deposits. The banking system, however, can create a multiple expansion of deposits. As each bank lends and creates a deposit, it loses reserves to other banks, which use them to increase their loans and thus create new deposits, until all excess reserves are used up.

If the required reserve ratio is 10 percent, then starting with new reserves of, say, $1,000, the most a bank can lend is $900, since it must keep $100 as reserves against the deposit it simultaneously sets up. When the borrower writes a check against this amount in his bank A, the payee deposits it in his bank B. Each new demand deposit that a bank receives creates an equal amount of new reserves. Bank B will now have additional reserves of $900, of which it must keep $90 in reserves, so it can lend out only $810. The total of new loans the banking system as a whole grants in this example will be ten times the initial amount of excess reserve, or $9,000: 900 + 810 + 729 + 656.1 + 590.5, and so on.

In a system with fractional reserve requirements, an increase in bank reserves can support a multiple expansion of deposits, and a decrease can result in a multiple contraction of deposits. The value of the multiplier depends on the required reserve ratio on deposits. A high required-reserve ratio lowers the value of the multiplier. A low required-reserve ratio raises the value of the multiplier.

In 2004, banks with a total of $7 million in checkable deposits were exempt from reserve requirements. Those with more than $7 million but less than $47.6 million in checkable deposits were required to keep 3 percent of such accounts as reserves, while those with checkable accounts amounting to $47.6 million or more were required to keep 10 percent. No reserves were required to be held against time deposits.

Even if there were no legal reserve requirements for banks, they would still maintain required clearing balances as reserves with the Federal Reserve, whose ability to control the volume of deposits would not be impaired. Banks would continue to keep reserves to enable them to clear debits arising from transactions with other banks, to obtain currency to meet depositors’ demands, and to avoid a deficit as a result of imbalances in clearings.

The currency component of the money supply, using the M2 definition of money, is far smaller than the deposit component. Currency includes both Federal Reserve notes and coins. The Board of Governors places an order with the U.S. Bureau of Engraving and Printing for Federal Reserve notes for all the Reserve Banks and then allocates the notes to each district Reserve Bank. Currently, the notes are no longer marked with the individual district seal. The Federal Reserve Banks typically hold the notes in their vaults until sold at face value to commercial banks, which pay private carriers to pick up the cash from their district Reserve Bank.

The Reserve Banks debit the commercial banks’ reserve accounts as payment for the notes their customers demand. When the demand for notes falls, the Reserve Banks accept a return flow of the notes from the commercial banks and credit their reserves.

The U.S. mints design and manufacture U.S. coins for distribution to Federal Reserve Banks. The Board of Governors places orders with the appropriate mints. The system buys coin at its face value by crediting the U.S. Treasury’s account at th

How Does The Real Money Supply Vary With Government Spending