Difference money supply and liquidity, which has an effect on inflation?
While many people talk about money supply and liquidity interchangeably, the reality is these are both very different concepts. While the term money simply refers to the supply of money, the term liquidity relates to the interplay between the supply of and the demand for money.
The money supply is one of the components of the domestic liquidity, and it is consisted of two main concepts; the amount cash outside the banking sector, and non-governmental current deposits in local currency within the banking sector.
On the other hand, the domestic liquidity includes the money supply with its two mentioned concepts as well as non-cash deposits in local currency, cash and non-cash deposits in foreign currency
The liquidity emerges once the quantity of money supplied and demanded are out of equilibrium due to the interplay between the supply of and the demand for money. The emergence of liquidity sets in motion an equilibrating process through changes in the prices of goods.
An increase in the supply of money typically lowers interest rates, which in turn, generates more investment and puts more money in the hands of consumers, thereby stimulating spending. Businesses respond by ordering more raw materials and increasing production.
Historically, measuring the money supply has shown that relationships exist between it and inflation and price levels; that is why the central bank works on controlling the money supply through increasing the interest rates.
The central bank limits the money supply via contractionary or hawkish monetary policy so interest rates rise and the cost of borrowing increases. This can dampen inflationary pressures, but also risk slowing down economic growth.
A central bank regulates the level of money supply within a country. Through monetary policy, a central bank can undertake actions that follow an expansionary or contractionary policy. A contractionary policy would involve the selling of Treasuries, removing money from circulating in the economy.
