What Is the Relationship Between Money Supply and GDP?

Money supply refers to all the currency and other liquid instruments in a country's economy. A country's money supply includes both cash and other types of deposits that can be used almost as easily as cash. The U.S. Federal Reserve System has published data on the money supply for many decades because of the effects that the money supply is believed to have on real economic activity and the price level.

The measures of money supply data that are published by the Federal Reserve on a weekly and monthly basis are referred to as M1 and M2. When measuring the money supply, most economists use the Federal Reserve's M1 and M2 measures. Money supply data from the Federal Reserve is published in reports that are available at 4:30 p.m. every Thursday. These reports appear in some Friday newspapers and are available online as well.

Gross domestic product (GDP) is another measurement that is usually published by a country's government. GDP is a measurement of the total value of all the finished goods and services produced within a country's borders within a specified period of time. GDP is usually assessed as a comprehensive indicator of a country’s overall economic health. In the U.S., the government releases data about the country's GDP on an annual and quarterly basis.

Nominal GDP refers to the GDP calculated at current market prices. Nominal GDP tends to rise with the money supply, but this is not always the case. Real GDP–also referred to as "constant-price," "inflation-corrected" or "constant-dollar GDP–is an inflation-adjusted measure of a country's GDP. Real GDP does not have as clear of a relationship with the money supply. Real GDP tends to be more influenced by the productivity of economic agents and businesses.

The relationship between money supply and the GDP also depends on whether you are taking a short-term or long-term view of the economy.

How the Money Supply Impacts Gross Domestic Product

According to many theories of macroeconomics, an increase in the supply of money should lower interest rates in the economy. An increase in the money supply means that more money is available for borrowing in the economy. This increase in supply–in accordance with the law of demand–tends to lower the price for borrowing money. When it is easier to borrow money, rates of consumption and lending (and borrowing) both tend to go up. In the short run, higher rates of consumption and lending and borrowing can be correlated with an increase in the total output of an economy and spending and, presumably, a country's GDP. Although this outcome is expected (and predicted by economists), it is not always the actual result.

The long-term impact of an increase in the money supply is more difficult to predict. Throughout history, there has been a strong tendency for the prices of assets–such as housing and stocks–to artificially rise following an increase in the money supply, or anything that results in a high level of liquidity entering the economy. This misallocation of capital can lead to waste and speculative investments, which can result in the rapid escalation of asset prices followed by a contraction (an economic cycle known as a bubble) or an economic recession, a significant decline in economic activity.

On the other hand, if prices are not misallocated, and the prices of assets do not artificially inflate, it's possible that in the long-term, the only impact of an increase in the money supply is higher prices than consumers normally would have faced.

Relationship Between GDP and the Money Supply

While a country's GDP is not a perfect representation of economic productivity and health, in general, a higher level of GDP is more desirable than a lower level. A country's GDP provides information about the size of its economy and the GDP growth rate is one of the best indicators of economic growth over time. The GDP per capita measurement also has a close correlation with the trend in living standards over time.

In general, when the GDP growth rate shows rising economic productivity, the value of money in circulation increases. This is because each unit of currency can subsequently be exchanged for more valuable goods and services.

Economic growth tends to have a natural deflationary effect, even if the supply of money does not shrink. Some evidence of this phenomenon can be observed in the technology sector, where innovations and technological advancements are growing faster than inflation; currently, the prices of televisions, cellphones, and computers tend to be falling.

Monetary Policy

There are many reasons why the money supply in a country may be growing. The central banks of countries may print more money. Banks may choose to lower their liquidity ratio, and therefore, be willing to lend a larger proportion of their funds to consumers and businesses. There can also be an influx of funds from abroad if a central bank buys up its currency from foreign exchanges in order to build up its foreign reserves. The government may also increase the money supply through its activities, primarily buying government securities. When the government buys bonds from investors, those people who were holding the bonds have more money to spend.

Any actions by central banks to increase or decrease the money supply are referred to under the umbrella term of monetary policy. The U.S. Federal Reserve has three general macroeconomic goals: price stability, sustainable economic growth, and high employment. Historically, the U.S. Federal Reserve has attempted many different policies to influence the size of the money supply in order to achieve those macroeconomic goals. However, in recent decades, research has shown that the relationship between growth in the money supply and the performance of the U.S. economy is becoming weaker. As a result, emphasis on using the money supply as the primary vehicle for monetary policy has waned.