The money supply and the difficulties of controlling it have been in the news lately. Following are questions and answers on this topic.

QUESTION: What is the money supply? Why does it matter? And why is it hard to control?

ANSWER: Let's start with money. People often think of only currency and coins as money. But they also treat their balances in checking accounts at banks and other financial institutions quite literally as "money in the bank" and use it accordingly.

Currency, coins and these checking account balances together make up the measure of the money supply known as M-1. In the week ended Jan. 6, the level of M-1 averaged $450.2 billion.

Q: What about money in a savings account or a money market mutual fund?

A: Money deposited in a passbook account or a money market fund is not as apt to be used to pay for day-to-day purchases. People tend to regard such accounts as savings accounts with the emphasis on savings, as opposed to a checking account. But the money is there, of course, and to take account of it, savings account balances, money fund shares, small denomination certificates of deposits and some other similar items are added to the currency, coins and checking deposits of M-1 to make up M-2. In December, the Fed estimated the level of M-2 as $1.842 trillion.

Q: Are there any more "Ms"?

A: Yes, one more, M-3. M-3 includes all the items in M-2 plus some others, such as large certificates of deposit that are still further removed from the cash in one's pocket.

Q: Okay, so there are three measures of the money supply. Why does the rate at which they grow matter?

A: It matters because there is a connection between the amount of money available and the level of economic activity. In a very general sense, the lower the rate of growth of money, the lower the rate of growth of the economy. But the connection is a very loose one, and it involves changes in the level of activity as measured in current dollars and not in terms of real units of output.

Q: "Current dollars?" What does that mean?

A: "Current dollars" means dollars worth whatever they will buy during the month or quarter or year in question. For instance, in current dollars the U.S. gross national product (total output of goods and services) rose from $2,626.1 billion in 1980 to $2,922.2 billion in 1981, an 11.3 percent increase. But once inflation is taken out, GNP went up only 1.9 percent.

Q: Why is this distinction important?

A: Because the current goal of monetary policy is to try to control inflation. Restricting the growth of money, however, can only slow down the rate of increase of current-dollar GNP. It does not affect only the inflation portion of the increase in current-dollar GNP. It also affects real output. This is a serious limitation on fighting inflation with monetary policies.

Some economists have argued that most of the resulting squeeze will fall on inflation, not real output, but the record of the past year or two suggests that real economic activity is hit every bit as hard as inflation.

Q: Wait a minute. Why is anything squeezed?

A: That goes back to the nature of the connection between money and economic activity. When consumers go into a store and make purchases, they may pay cash, write a check or use a credit card. For larger items--cars or houses--buyers often borrow a larger portion of the cost from a bank or other lender.

Businesses have the same sorts of choices, perhaps buying items they need using cash on hand or short-term loans from banks. To finance major investments in plants and machines, businesses may issue long-term bonds.

All of these transactions require money in one form or another. If the buyer borrows the money, then the lender must have it to lend. So the less money there is available, the fewer such transactions can occur.

When there is more demand for money than there is available, the cost of money--the interest rate--begins to rise. As rates go up, some individuals or businesses decide that whatever transaction they had in mind has become too costly.

Generally speaking, if there are fewer buyers demanding fewer goods, less of those goods will be produced and unemployment may begin to rise. At the same time, producers likely will find it harder to raise prices since there is less demand for their goods, and inflation may come down.

Q: Does all this happen right away? Does the economy slow down or speed up immediately?

A: Not necessarily. Economists disagree just how quickly a change in the rate of money growth can affect either inflation or real output, but most believe the economy responds with a lag of anywhere from six months to two years or more.

Q: With that loose a connection between money growth and the economy, it must be pretty hard to use money as a lever to move the economy one way or another. But why is it so hard to control money growth in the first place?

A: There are several reasons. Perhaps the most important is that the bulk of all of the measures of money, even M-1, consists largely of deposits in financial institutions, not cash. In fact, the Federal Reserve essentially provides whatever cash the public demands. The difficulty lies in trying to influence changes in deposits, which the Fed must do indirectly.

When banks and other financial institutions receive deposits, they must set aside a portion of that money in the form of reserves. The reserves generally must be held in the form of vault cash or as noninterest bearing deposits at Federal Reserve banks. Under legislation now being implemented, most state-chartered banks, savings and loan associations, mutual savings banks and credit unions are only beginning to be required to place their reserves with the Fed.

As customers increase their deposits at a financial institution, that institution's need for reserves increases. If it does not have enough, it can borrow from other institutions in what is known as the federal funds market or directly from the Fed.

The Fed tries to manipulate the level of deposits, and thus of the money supply, by adding reserves to the banking system or by taking them away. It does this by buying or selling government securities. When it sells securities, the Fed takes money out of the banks and thus lowers the amount of reserves. When it buys securities, it adds money to the system and expands the level of reserves.

When the amount of reserves the Fed has supplied is less than the banking system needs, the interest rate on reserves borrowed by one bank from another rises and some banks turn to the Fed to borrow. But other banks may choose to shrink the level of deposits they have rather than seek more reserves.

The Fed can control the level of reserves fairly closely, but it has far less control over the translation of reserve availability into money. The banking system itself creates money by lending it. Since the financial institutions only must set aside a portion of a dollar deposited with them, they can take the remainder and lend it.

A borrower who gets the remainder likely will deposit it in one institution or another, or if he paid it immediately to someone else, then they would deposit it. Once again, the institution that got that deposit could lend part of it. And so on and on.

In this fashion, the nation's commercial banks on Dec. 30 had $1.24 trillion in deposits supported by about $40 billion in reserves.

But this expansion process is far from automatic. The state of the economy can speed it up or slow it down. For instance, many economists are quite puzzled at the recent rapid growth in the money supply at the same time the economy is falling deeper into recession.

In addition, there are numerous technical problems associated with knowing just what is going on in financial markets at a given moment when the Fed must decide to buy or sell securities to change the level of reserves.

Q: Suppose the Fed were lucky enough to hit its money growth target on the nose. Would that mean the level of economic activity in "current dollars" would be exactly what the Fed wanted.

A: Not necessarily. In the short run, the linkage between money and the economy is very loose. Normally, in a recession, it may be difficult if not impossible to speed up money growth because there are not enough customers for bank loans to turn added reserves into a larger money supply.