What do Money Supply, Inflation and Forex Have in Common?

The subject of inflation and money supply is an important basic topic for anyone who wants to learn forex. Money supply statistics, which have important consequences for inflation expectations, are usually released on a monthly basis by central banks.

While the concept of money supply is not hard to understand, traders have not been willing to learn much about it, and this piece of data is often neglected by the markets as a result. Or so says trader lore. In fact the issue is a bit more complicated, and we’ll examine it here.

Put simply, money supply is an abstract concept that measures the total amount of money (in other words, credit) in an economy. All paper money and coins, short and long term bank deposits, derivatives instruments, and similar tools that create capital for lenders and borrowers are included in the formula that calculates money supply.

As with most other matters, however, different central banks have different methods for deriving data, (for example, some central banks do not include all derivatives products in the calculation), but beyond the technical details, money supply is a simple and straightforward concept.

Thus, money supply is a basic measure of the amount of money available in an economy. Although we would expect money supply to be of great importance for forex trends on this basis, as discussed above, we find that the markets usually ignore the data, and do not attach great significance to it. What is the cause of this phenomenon?

First of all, the connection between money supply and economic activity is not very straightforward. Another component, called the velocity of money, or the money factor, is very important in determining how vigorous economic actors are in using the credit available to them for generating economic activity.

If the velocity of money is low in a period in comparison to that preceding it, we find that an increasing level of money supply is necessary to generate the same economic activity. In other words, money supply by itself doesn’t say much on how active an economy is, and by inference, how much inflationary potential it possesses.

Another factor that has been reducing the appeal of money supply as a predictive tool is the indifferent attitude of central banks to this statistic over the years.

The much-publicized expansionary policies of the US Federal Reserve lead many speculators to assume that this piece of data has little predictive value, since central banks will not stop the expansion of credit just because money supply is increasing. Indeed, the Federal Reserve doesn’t even attach great significance to this data.

Perhaps one other factor contributing to the unpopularity of this data is its abstract nature. Since we can get a good idea of inflation from CPI, and of growth from the GDP, what is the purpose of the money supply data?

It wasn’t always like this in the past, since before this decade traders would keep an eye on money supply growth to guess future interest rates, in a way similar to what they do with bond prices and rates today. So, to conclude this brief examination, let’s note that there is no reason to think that money supply will never again be regarded as an important variable in traders’ calculations.

To be there when this change occurs, and to perfect your grasp of this important topic, we suggest that you seek a good forex course to enhance your knowledge.

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