What is Money Supply?

Money supply is like counting up a kid’s money…

First, perhaps you open up their piggy bank and dump out all the bills and coins. The total of that is like The Fed’s M1 measure of money supply. Have the parents opened up a savings account for the kid? Add in that balance, and you’ve got the equivalent of the M2 money supply. The money supply of an economy is basically this exercise on an economy-wide scale.

Money supply is a measure of the amount of money that exists in a country or economy. There are many ways to measure the money supply, each measuring a different kind of money in circulation.

Though the measures of money supply differ, the primary reason to measure it is to find the amount of easily spendable money that exists in an economy. People and businesses often need access to cash, coins, and other sources of spendable funds to conduct business. Maintaining a healthy supply of money is essential to keeping an economy running smoothly.

Economists have often tracked changes in the money supply compared with changes in other economic indicators and measures, such as inflation (the phenomenon of money losing value over time).

For example, the economist Milton Friedman argued that the money supply has a direct effect on prices and inflation. If there is more money in an economy, inflation is likely to rise and goods will cost more to buy. Similarly, constraining the money supply can help limit inflation.

In recent years, the relationship between the supply of money and economic indicators like Gross Domestic Product (GDP) (the total economic output of a country) and inflation has not been stable. The money supply has increased significantly without significantly impacting inflation.

The Federal Reserve’s Open Market Committee is responsible for guiding the nation’s monetary policy and continues to review the money supply as an important indicator. However, it also considers other factors when making decisions about expanding or contracting the money supply.

There are three primary measures of money supply. Each measure includes different types of money.

M1 measures only the most liquid (easily spendable) forms of money. It includes things such as:

• Coins
• Bills
• Balances of checking accounts and other demand deposits
• Traveler’s checks
• Other immediately spendable money

The easiest way to think of M1 is to think of it including everything you could use to buy something right now, without having to wait for something like a bank transfer to clear. M1 does not include coins and bills held at Federal Reserve System banks because that money is not circulating in the economy.

One thing that causes a wrinkle in the definition of M1 is that people can spend some forms of money measured in M1 more easily than others. For example, a merchant will almost never refuse cash, coins, or a traveler’s or certified check guaranteed by a bank. However, the merchant might not accept a personal check written against a checking account, because the check might bounce.

Even though the balance of the checking account is part of M1, it may be harder to spend than other forms of M1.

Another thing to keep in mind is that lines of credit, such as credit cards, don’t contribute to the money supply despite the fact that they’re easy to use for immediate spending. Credit cards simply draw money from the card issuer. The card issuer offering a higher credit limit doesn’t create new money.

M2 includes all of the money that is part of the M1 money supply, plus other relatively liquid forms of currency. This includes:

• Savings deposits
• Money market funds
• Certificates of deposit (CDs) and other time deposits (accounts with limits on withdrawals) of less than two years

If you needed to spend the money you have in one of these types of accounts, you could access the funds relatively quickly. However, it would take more effort than spending money that is part of the M1 money supply. For example, you would likely need to visit a bank or ATM to make a withdrawal from your savings account or cash in a CD.

Because M2 includes all of M1 plus additional sources of money, M2 is generally larger than the M1 money supply.

Often, the difference between M1 and M2 can be quite blurry, especially as modern technology has made banking easier. The difference between money in an online savings account and online checking account is relatively small given that many banks allow immediate transfers between the two. That makes the difference in liquidity between some forms of M1 and M2 small.

M3 is a measure used by some central banks to measure the supply of money. In most cases, M3 is very similar to M2. For example, the European Central Bank (ECB) considers M3 to include all of M1 and M2, plus any deposit accounts that the holder can redeem with three months of notice or less. This makes the ECB’s definition of M3 very similar to M2. The Federal Reserve has not used M3 since 2006.

Adjusting the money supply is one of the primary ways that central banks manage their nations’ economic systems. Altering the supply of money can impact several economic measures, including inflation, interest rates, and gross domestic product (GDP).

In general, economists agree that a country’s long-run GDP is difficult to change. However, they can create short-term changes by adjusting the supply of money. For example, many economists believe that a country can reduce the impact of a recession or escape recession more quickly by increasing the money supply.

Increasing the money supply tends to make it easier for consumers and businesses to borrow and spend money, which typically spurs economic growth. So, increasing money supply during a recession makes it easier to recover by making it easier to spend.

Similarly, during periods of growth, reducing the money supply can prevent inflation from rising excessively. Most economists agree that some amount of inflation is healthy, while high levels are bad for an economy. For example, the Federal Reserve targets 2% inflation in the long run. Reducing the money supply can help reduce prices, decreasing the rate of inflation.

Typically, as the supply of money in an economy increases, inflation rises. As the money supply drops, inflation decreases. In extreme cases, deflation (falling prices and money gaining value) could occur if the money supply drops by a large amount.

Growth in the money supply of an economy is natural as the economy grows and produces more goods and services. Inflation tends to happen when the supply of money grows at a rate that is faster than the growth of the economy. Because the economy isn’t producing enough value to keep up with the increasing amount of money available, prices must increase to keep the relative purchasing power of that money the same.

One formula that people use to measure the impact of money supply on inflation is:

Money supply * Velocity = Price * Output

Velocity is the number of times that a dollar is spent in a single year. If $100 exists in an economy, and $500 in spending occurs, the velocity of spending is five.

If any of the measures change, one or more other measures must also change to keep the equation balanced.

If the money supply increases while velocity and output remain constant, prices must increase, producing inflation. If output increases, the money supply can safely increase without impacting prices.

The equation indicates that factors outside of the money supply and output can have an influence on inflation, which is part of why it can be difficult to predict how a change in money supply might impact the economy. If spending money becomes easier, the velocity of spending can increase, creating inflation even without a change in the money supply.

The money supply is significant because it is one of the primary tools that central banks, like the Federal Reserve, use to manage the economy.

Most economists agree that money supply is one of the direct influencers of inflation. The more the supply of money increases, the higher inflation will be. Slower growth in the money supply slows inflation, and deflation (falling prices and money gaining value) can occur if the money supply begins to shrink.

Central banks carefully adjust the money supply of an economy in an attempt to create the conditions they desire. The Federal Reserve primarily does this through a process called open market operations. In open market operations, the Fed buys and sells government securities, such as bonds, on the open market. Buying many securities puts additional money into the financial system. Selling securities removes money from the system.

The Fed uses the changes in money supply to influence a benchmark short-term interest rate, the federal funds rate. This interest rate is the rate at which banks lend money to each other overnight. Banks frequently need to loan or borrow money overnight to satisfy rules about how much money they must have on hand compared to customer deposits.

By influencing the federal funds rate through the money supply, the Fed can affect other interest rates. Although it initially affects short-term rates, it can have an effect on longer-term rates depending on economic conditions. Generally, when the federal funds rate drops, the interest rates on bank accounts and loans decrease (although there can be a lag). Lower rates discourage people from saving and encourage them to borrow money, which can spur economic growth. Higher rates encourage saving and reduce spending, which can fight excessive inflation.

As of January 2021, the M1 money supply in the United States is $6.80T, an increase of more than 400% since the beginning of 2008. The increase in the money supply largely came as a result of the 2008 recession. The government began slowing the growth of the money supply in recent years, but may begin growing it again in response to the economic conditions caused by the coronavirus pandemic.

As of January 2021, the M2 money supply in the U.S. is $19.54T, an increase of more than 250% since 2008.

The Fed stopped reporting the M3 money supply in March 2006, because the measure was no longer providing additional value beyond the information contained in the measurement of M2.