The money supply is the total amount of money available in an economy at a particular point in time. The quantity of money is probably the most important concept in economic theory, since it affects the price level. The increase in money supply causes price inflation, while the decrease in money supply leads to price deflation.
However, there is actually no agreement on how to define money. Thus, there are many definition and metrics of money supply. One of them is the monetary base. It is the most liquid type of money circulating in the economy and created by the central bank. The monetary base consists of physical money (coins, notes) and of the commercial banks’ deposits with the central bank. However, the monetary base is only a part of the money supply. Actually, the actual amount of money in contemporary economies is significantly larger than the monetary base. In the current monetary system based on fractional-reserve banking, commercial banks create about 90 percent of money supply in the form of demand deposits, time deposits, saving accounts etc. These components of the money supply are reflected in broad aggregates such as M1 or M2. M1 is the total of physical currency outside of the private banking system plus the amount of demand deposits, travelers checks and other checkable deposits. M2 includes all M1 components and even less liquid assets, such as most savings accounts, money market accounts, retail money market mutual funds, and small denomination time deposits (certificates of deposit under $100,000).
Money Supply and Gold
Many analysts claim that the changes in the money supply drive the price of gold. It is believed that more money relative to a fixed supply of the yellow metal leads to a higher gold price and vice-versa. The standard explanation goes as follows: since inflation is caused by an increase in the money supply, and since gold is a hedge against inflation, money supply growth positively affects the price of gold. However, in reality, the relationship between money supply and gold is not so simple. Let’s look at the chart below.
Chart 1: Gold price (yellow line, right axis, PM fixing), St. Louis adjusted monetary base (red line, left axis) and M2 money supply (green line, left axis) from 1970 to 2015.
Sure, there were periods when gold was rising in tandem with the money supply, e.g. in the 1970s and 2000s. However, the yellow metal was in a bear market during the 1980s, 1990s and since 2011, despite the rising money supply (as indicated by the orange rectangles). The price of gold has fallen since 2011 by more than one-third, while the monetary base has increased by half and the M2 supply has risen by more than 25 percent. Why did the price of gold decline when the monetary base’s growth resembled a hockey stick in the past few years? First, the monetary base is only a part of the total money supply and the scale of increases in the M2 – a much broader measure of money supply – were not unusual. In other words, the Fed was printing like mad, but commercial banks were not willing to increase the money supply at a similar rate. Second, it also matters where the new money supply flows. Quantitative easing went mainly into the asset markets. These monetary inflows made stock and bonds markets more appealing, especially when the central banks regained public trust after the Fed announced the infinite QE3.
To sum up, there is no simple one-to-one correlation between the price of gold and money supply growth, as the gold price dynamics depend on a broader economic context. Gold may serve as a monetary pumping hedge only when there is a relatively high and accelerating pace of money supply growth – flowing into consumer goods rather than asset markets – usually accompanied by fears about the current state of the U.S. dollar and the global monetary system.
We encourage you to learn more about gold – not only how it is affected by the money supply, but also how to successfully use gold as an investment and how to profitably trade it. A great way to start is to sign up for our gold newsletter today. It's free and if you don't like it, you can easily unsubscribe.