How does the Fed expand the money supply to keep up with the growing economy?

Mudassir Ali
Jan 21, 2020 04:49 PM 0 Answers
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Mudassir Ali
- Jan 21, 2020 04:49 PM

I’ll bet you are asking this question because you think the size of the money supply is what determines the amount of spending needed to pay for the increasing amount of goods and services being sold.

However that is not true. As the economy grows you need to increase spending, and spending is the product of the total value of the money supply (M) times the velocity of money (V)

The velocity of money (V) is the average number of times each unit of the money supply is used for spending.

If we get the economy going and we are spending more and producing more, then we can increase our spending just by increasing the velocity of money.

If we do that, then spending (M*V) will increase just from V increasing.

So the Central Bank can do monetary policy without really being concerned that we have an adequate amount of money in the money supply for whatever level of spending is occurring. That is, the Central Bank can either increase or decrease the money supply, to stimulate or slow the economy, and not worry about whether the money supply is adequate to support necessary and desired spending. The Velocity of money normally can adjust to allow that spending to be what ever level is needed.

All that being said,the velocity of money can have limits as to how high it is able to go. This means, that a certain amount of permanent increase in the money supply will be necessary over the long run so that the amount of spending is able to be adequate. Generally, total nominal spending increases over time due to baseline inflation and the need to pay for the sales of extra production that occurs due to increases in productivity and population.

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