Narrow Money Definition Supply Broad Money Component

Narrow Money Definition

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Its primary advantage is that it facilitates immediate monetary transactions and hence is a key measure of the purchasing power of people in an economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more. Tracking narrow money helps authorities regulate the overall money supply in the economy through its monetary policies. Narrow money is just one end of the total money supply spectrum. The other is broad money which includes less liquid financial assetsFinancial AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more.

Key Takeaways

Narrow money, referred to as M0 and M1, is the most liquid form of money, including notes, coins, and demand deposits.Typical applications of narrow money include paying in currency, writing checks, or ATM withdrawals from savings accounts for commercial purposes.Its most important feature is that it is easily accessible for commercial transactions.It facilitates monetary authorities to formulate policies that ensure a balance between inflation and economic growth.

Narrow Money Explained

Narrow money is a component of the money supply that includes only the most liquid form of money held by the public in an economy. It comprises notes, coins, and all the deposits that individuals have in their bank accounts. However, note that foreign currencies don’t come under this category.

It has no alternative in day-to-day life transactions. No other class of money comes closer to beating narrow money concerning its immediate usage, whether paying cash for commodities Commodities A commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units.read moreor writing a check for an employee. This ease of access makes it highly liquid.

In a real-life scenario, any form of immediate currency used to make purchases will be considered narrow cash. It does not matter whether it is in the pocket, bag, or under the couch. The key thing here is that the money is in circulation, and it does not matter if the money goes to someone else after making purchases.

Note that demand or checking deposits that people hold in their bank accounts fall in this category. This is because people can easily withdraw them on-demand or write a check to make payments. It makes them as liquid as coins and notes, earning them the right to fall under this class.

Components of Narrow Money

Monetary authorities segregate the total stock of money into monetary aggregates to measure the money supply in an economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more. They are labeled as MB/M0, M1, M2, and M3.

Monetary base (MB/M0) = Currency in circulation + Federal reserve balances

M1 = Currency + Demand deposits + Other checkable deposits

M2 = M1 + Term deposits

M3 = M2 + Large term deposits (not measured by federal reserve anymore)

Components of narrow money include all elements of MB/M0 and M1.

Examples

Example #1

John is going for a ride with his friends, and suddenly, he sees an ice-cream parlor. He pulls out the requisite cash from his wallet and makes immediate payment to the ice cream parlor. However, on other occasions when he forgets to carry cash in his pocket, he makes up for it by going to the ATM and withdrawing the required amount from his savings account for ice cream using his debit card.

In both cases, narrow money is in operation. The first case was a case of a highly liquid transaction involving notes or coins, while in the second case, it took just a bit of time to encash because of the involvement of demand depositsDemand DepositsMoney deposited with a bank or financial institution that can be withdrawn without notice is known as a demand deposit. Due to the shorter lock-in time, it does not pay any interest or a nominal amount of interest.read more (withdrawing money from a savings account).

Example #2

Recently, the Russian invasion of Ukraine has brought about a sharp rise in global crude oil prices. However, Nigeria is not likely to benefit from the surge due to its limited crude oil production.

While rising crude oil prices may leave more money in circulation, it will also put pressure on foreign reserves and exchange rates to meet the demands of the higher cost of imported oil. On the one hand, this will increase narrow money as more money will be in circulation due to rising oil prices. But on the other hand, a depleted foreign reserve may terribly affect Nigeria’s gross domestic product (GDP).

With such pressures mounting on the Nigerian economy, Nigeria is lingering on inflation and depreciation of its currencyDepreciation Of Its CurrencyCurrency depreciation is the fall in a country’s currency exchange value compared to other currencies in a floating rate system based on trade imports and exports. For example, an increase in demand for foreign products results in more imports, resulting in foreign currency investing, resulting in domestic currency depreciation.read more Naira against the dollar. It is a classic case of how an increase in narrow money can lead to inflation if not coupled with a positive GDP growth rate.

Narrow Money and Broad Money

Broad money constitutes a larger segment of the money supply comprising of both liquid and non-liquid money. It includes all components of M2 and M3. It usually consists of deposits that take more than 24 hours before they reach maturity for transactions.

At the same time, narrow money (M0 and M1) forms a small part of the money supply. Unlike broad money, which takes longer to mature, users can use it for instant transactions because of its liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more.

While narrow money presents a smaller picture of the economy’s health, broad money is the most comprehensive method to calculate the total amount of money in an economy. This is because it includes liquid money plus all other assets that are convertible into cash.

A simple example of broad money would be mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more. Mutual funds can’t be converted to cash until they reach maturity, which may be six months or six years, depending on the chosen scheme. Converting shares into cash is another classic example of broad money usage.

Importance

Narrow money shows the status of money supply within an economy. Though limited in measure, it goes a long way in determining the overall economic health of an economy. It is because it reveals the purchasing power of people, which is directly related to demand and inflation.

Besides, the money supply also has a strong relationship with economic activity. Therefore, if the money supply is not regulated, it may result in inflation and higher prices. Thus, monetary authorities try to make a trade-off between inflation and economic growthEconomic GrowthEconomic growth refers to an increase in the aggregated production and market value of economic commodities and services in an economy over a specific period.read more by controlling the money supply through effective monetary policiesMonetary PoliciesMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more.

Hence, measuring narrow money aids policymakers in predicting and controlling inflation and rising interest rates. However, the federal bank does not entirely depend on money stocks to formulate and implement its policies. Rather, it also pays attention to interest rates to carry out its policy implementations.