Prior to determining an appropriate economic policy, economists must have an idea of the amount of money that is in circulation, along with the amount of other types of assets that will provide access to cash. Economists gauge the money supply using three measures. They are:
. Ml . M2 . M3
Ml is the largest and most liquid measure of the nation's money supply and it includes:
• Demand deposits (Checking accounts)
Includes all the measures in Ml plus:
• Money market instruments
• Time deposits of less than $100,000 . Negotiable CDs exceeding $100,000
• Overnight repurchase agreements
Includes all of the measures in Ml and M2 plus
• Time deposits greater than $100,000
• Repurchase agreements with maturities greater than 1 day
Disintermediation occurs when people take their money out of low yielding accounts offered by financial intermediaries or banks and invest money in higher yielding investments.
The Federal Reserve Board often will use moral suasion as a way to influence the economy. The Fed is very powerful and very closely watched. By simply implying or expressing their views on the economy, they can slightly influence the economy.
Monetarists believe that a well-managed money supply, with an increasing bias, will produce price stability and will promote the overall economic health of the economy. Milton Friedman is believed to be the founder of the monetarist movement.
Fiscal policy is controlled by the president and Congress and determines how they manage the budget and government expenditures to help steer the economy through the business cycle. Fiscal policy may change the levels of:
• Federal spending
• Federal taxation
• Creation or use of federal budget deficits or surpluses
Fiscal policy assumes that the government can influence the economy by adjusting its level of spending and taxation. If the government wanted to stimulate the economy, it may increase spending. The assumption here is that as the government spends more, it will increase aggregate demand and, therefore, productivity. Additionally, if the government wanted to stimulate the economy, it may reduce the level of taxation. As the government reduces taxes, it leaves a larger portion of earnings for the consumers and businesses to spend. This should also have a positive impact on aggregate demand. Alternatively, if the government wanted to slow down the economy, it may reduce spending to lower the level of aggregate demand or raise taxes to reduce demand by taking money out of the hands of the consumers. John Maynard Keynes believed that it was the duty of the government to be involved with controlling the direction of the economy and the nation's overall economic health.
As both the Federal Reserve Board and the government monitor the overall health of the U.S. economy, they look at various indicators some of which are:
• Consumer price index
• Inflation/deflation . Real GDP
CONSUMER PRICE INDEX (CPI)
The consumer price index is made up of a basket of goods and services that consumers most often use in their daily lives. The consumer price index is used to measure the rate of change in overall prices. A CPI that is rising would indicate that prices are going up and that inflation is present. A falling CPI would indicate that prices are falling and deflation is present.
Inflation is the persistent increase in prices, while deflation is the persistent decrease in prices. Both economic conditions can harm a county's economy. Inflation will eat away at the purchasing power of the dollar and results in higher prices for goods and services. Deflation will erode corporate profits as weak demand in the market place drives prices for goods and services lower.
Real GDP is adjusted for the effects of inflation or deflation over time. GDP is measured in constant dollars so that the gain or loss of the dollar's purchasing power will not show as a change in the overall productivity of the economy.
Both monetary policy and fiscal policy have a major effect on the stock market as a whole.
The following are bullish for the stock market:
• Falling interest rates
• Increasing money supply
• Increase in government spending
• Falling taxes
The following are bearish for the stock market:
• Increasing taxes
• Increasing interest rates
• Falling government spending
• Falling money supply
INTERNATIONAL MONETARY CONSIDERATIONS
The world has become a global marketplace. Each country's economy is affected to some degree by the economies of other countries. Currency values relative to other currencies will impact a country's international trade and the balance of payments. The amount of another country's currency that may be received for a country's domestic currency is known as the exchange rate. The balance of payments measures the net inflow (surplus) or outflow (deficit) of money. The largest component of the balance of payments is the balance of trade. As the exchange rates fluctuate, one country's goods may become more expensive, while another county's goods become less expensive. A weak currency benefits exporters, while a strong currency benefits importers.