Archive | June, 2012
Image

Money Supply

27 Jun

Money Supply

Advertisements

Indicator 3 – Money Supply

27 Jun

In previous posts I have alluded to the fact that the Federal Reserve (“The Fed”) uses data such as the real GDP, CCI and other related economic indicators to adjust monetary policy.  Therefore, this post is dedicated to defining what is meant by the “money supply” and the methods The Fed uses to regulate it.

The money supply is broken down into aggregates:

M0:  Physical currency. A measure of the money supply which combines any liquid or cash assets held within a central bank and the amount of physical currency circulating in the economy. M0 (M-zero) is the most liquid measure of the money supply. It only includes cash or assets that could quickly be converted into currency. This measure is known as narrow money because it is the smallest measure of the money supply.

M1:  M0 + demand deposits, which are checking accounts. This is used as a measurement for economists trying to quantify the amount of money in circulation. The M1 is a very liquid measure of the money supply, as it contains cash and assets that can quickly be converted to currency.

M2:  M1 + small time deposits (less than $100,000), savings deposits, and non-institutional money-market funds. M2 is a broader classification of money than M1. Economists use M2 when looking to quantify the amount of money in circulation and trying to explain different economic monetary conditions – M2 is a key economic indicator used to forecast inflation.

M3:  M2 + all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets. The broadest measure of money; it is used by economists to estimate the entire supply of money within an economy.  The Federal Reserve previously published data on three monetary aggregates (M1, M2 and M3), but ceased publication of M3 in the spring of 2006.

Some economists believe that M2’s relevancy has waned over the past 20 years.  For many years this monetary measurement closely paralleled the growth or contraction of the U.S. economy and overall changes in prices.  Over the past two decades, however, a bevy of changes including the introduction of new depository products, the movement of consumer funds from bank deposits to investment accounts and the internationalization of the economy has caused the money supply data to fall out of sync with other economic indicators.

Nevertheless, the Federal Reserve and some economists and analysts pay attention to the longer-term trends in growth or reduction of the money supply, particularly the six-month figures.  And the Federal Reserve retains its power to increase the money supply – the three ways that it does this are: 1) through changing the required reserve ratio (the amount banks must hold in reserve as a percentage of demand deposits), 2) allowing banks to borrow from it (The Fed) at the discount rate, and 3) conducting open market operations (buying and selling bonds).

In short, The Fed controls the money supply in the U.S. by controlling the amount of loans made by commercial banks.  New loans are usually in the form of increased checking account balances, and since checkable deposits are part of the money supply, the money supply increases when new loans are made and decreases when loans decrease.

A brief analysis of this indicator raises more topics for further analysis:

1.  What are the implications of a fiat currency system (i.e. a currency system which has no intrinsic value and cannot be redeemed for specie or any commodity, but is made legal tender through government decree) on the money supply and the economy?

2.  What impact has the explosion in credit (which is not included in the money supply) had on the economy?

3.   What are the implications of flat-lined M0 and M1 (money outside the banking system) compared to an explosion of M2 and M3 money supply within the banking system?

Psychology and Markets

13 Jun

An assortment of good reads on psychology, human behavior and markets (no particular order):

  1. Free Market Madness by Peter Ubel
  2. Is Greed Good? By Christoph Uhlhaas
  3. Why We Buy by Paco Underhill
  4. Predictably Irrational by Dan Ariely
  5. Driven by Paul R. Lawrence and Nitin Nohria
  6. Fooled by Randomness by Nassim Taleb
  7. Nudge by Richard Thaler
  8. Blink by Malcolm Gladwell
  9. Blunder by Zachary Shore
  10. Stuck by Anneli Rufus

 

Indicator 2 – Consumer Confidence Index (CCI)

9 Jun

Image

Perhaps I should have begun the series with this indicator.  The health of the economy is determined as much (if not more so) by psychology as it is by production numbers.  As a psychological concept; however, consumer confidence can be difficult to measure. (Note to self – post articles on psychology and markets).

The U.S. Consumer Confidence Index (CCI) is an indicator designed to measure consumer confidence, which is defined as the degree of optimism on the state of the economy that consumers are expressing through their activities of savings and spending.  In the United States consumer confidence is issued monthly by The Conference Board, an independent economic research organization, and is based on survey responses by 5,000 households.  Opinions on current conditions make up 40% of the index, with expectations of future conditions comprising the remaining 60%.  The survey consists of five questions that ask the respondents’ opinions about the following:

  • Current business conditions
  • Business conditions for the next six months
  • Current employment conditions
  • Employment conditions for the next six months
  • Total income for the next six months

Such measurement is indicative of the consumption component level (or 70%) of the gross domestic product.  The Consumer Confidence Index was started in 1967 and is bench-marked to 1985 = 100. This year was chosen because it was neither a peak nor a trough.

In simple terms, increased consumer confidence indicates economic growth in which consumers are spending money, indicating higher consumption.  Decreasing consumer confidence implies slowing economic growth, and so consumers are likely to decrease their spending.  The idea is that the more confident people feel about the economy and their jobs and incomes, the more likely they are to make purchases.  Declining consumer confidence is a sign of slowing economic growth and may indicate that the economy is headed into trouble.  The Federal Reserve looks at the CCI when determining interest rate changes.

In general, the CCI is considered a lagging indicator, which means it follows economic trends.  It lags because most people do not really feel that the economy has changed until after the fact.

But what about using consumer confidence as a predictor of future economic activity and strength?  Several economists tested whether the value of the index from a month, say, January, was able to improve projections of February’s consumption growth.  They concluded that when consumer confidence is used as the only variable, it can significantly improve these forecasts.  However; consumer confidence is not data with long-term forecasting powers.

The CCI for May 2012 stands at 64.9 – down from a revised 68.7 in April 2012.  The May figure, which represents the biggest drop since October 2011 when the measure fell about 6 points, shows that consumers need more encouraging news before their concerns about the economy start to dissipate. Despite easing gas prices, Americans continue to be concerned about a disappointing job market, declining home values, big drops in the stock market and a worsening European economy that they fear will negatively impact the U.S.   May’s figure is significantly below the 90 reading that indicates a healthy economy. The measure hasn’t been near that level since December 2007. But the latest reading is still well above the 40 figure reached last October and the all-time low of 25.3 in February 2009.

2012 B-School Summer Reading List

3 Jun

http://www.businessweek.com/articles/2012-05-22/summer-reading-list-the-b-school-edition