Money Supply Definition: Types and How It Affects the Economy (2024)

What Is the Money Supply?

The money supply is the sum total of all of the currency and other liquid assets in a country's economy on the date measured. The money supply includes all cash in circulation and all bank deposits that the account holder can easily convert to cash.

Governments issue paper currency and coins through their central banks or treasuries, or a combination of both. In order to keep the economy stable, banking regulators increase or reduce the available money supply through policy changes and regulatory decisions.

Key Takeaways

  • The money supply is the total amount of cash and cash equivalents such as savings accounts that is circulating in an economy at a given point in time.
  • Variations of the money supply number take into account non-cash items like credit and loans.
  • In the U.S., the Federal Reserve tracks the money supply from month to month.
  • The Fed also influences the money supply, through actions that increase or decrease the amount of cash in the system.
  • Monetarists, who view the money supply as the main driver of demand in an economy, believe that increasing the money supply leads to inflation.

Money Supply Definition: Types and How It Affects the Economy (1)

Tracking the Money Supply

The Federal Reserve website has a running account of the U.S. money supply month by month going back to 1999. (The Fed refers to the money supply as the money stock.)

Understanding Money Supply

In the United States, the Federal Reserve, known as the Fed, is the policy-making body that regulates the money supply.

Its economists track the money supply over time in order to determine whether too much money is flowing, which can lead to inflation, or too little money is flowing, which can cause deflation.

The Fed has a couple of weapons to use in order to keep the economy growing at a reasonable level.

  • It controls interest rates by setting the key rates that it charges to the nation's banks for the overnight loans of government money that keep the banking system running. The rates for all other loans are derived from those federal lending rates.
  • It adds or removes cash from the system by changing the amount of money that flows to banks for use in loans to businesses and consumers.

The money supply is tracked over time as a key factor in analyzing the health of the economy, pinpointing its weak spots, and developing policies to correct the weaknesses.

In its public releases, the Fed generally refers to the money supply as the money stock.

$19.93 trillion

As of February 2023, the seasonally-adjusted M1 money supply was 19.34 trillion, according to the Federal Reserve.

Effect of Money Supply on the Economy

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. The increased business activity raises the demand for labor.

The opposite can occur if the money supply falls or when its growth rate declines. Banks lend less, businesses put off new projects, and consumer demand for home mortgages and car loans declines.

Change in the money supply has long been considered to be a key factor in driving economic performance and business cycles. Macroeconomic schools of thought that focus heavily on the role of money supply include Irving Fisher's Quantity Theory of Money, Monetarism, and Austrian Business Cycle Theory.

Historically, measuring the money supply has shown that there are relationships between money supply and inflation and between money supply and price levels.

However, since 2000, these relationships have become less predictable, reducing their reliability as a guide for monetary policy. Although money supply measures are still widely used, they are among a number of economic measures that economists and the Federal Reserve collect, track, and review.

The Money Supply Numbers: M1, M2 and Beyond

The Federal Reserve tracks two distinct numbers on the nation's money supply and labels them M1 and M2. Each category includes or excludes specific kinds of money. There is yet another number, the M3, but its reporting was discontinued by the Fed in 2006.

There's also an MO and an MB, but these are generally included in the main categories rather than being reportedly separately.

All of the categories are an accounting of the amount of cash in the economy, but each category has a slightly different definition of "cash," or liquid assets.

The M1

M1, also called narrow money, is often synonymous with "money supply" in reports from the financial media. This is a count of all of the notes and coins that are in circulation, whether they're in someone's wallet or in a bank teller's drawer, plus other money equivalents that can be converted easily to cash. A regular bank savings account, for example, is a money equivalent. The account holder can convert those savings to cash at any time and instantly.

The M2

M2 includes M1 plus short-term time deposits in banks and money market funds.

Generally, less than a year is considered short-term.

The M3, the MO, and the MB

The M3, the MO, and the MB are not separately represented in the Federal Reserve reports on money supply.

  • M3, now discontinued, included M2 plus long-term deposits. The Federal Reserve decided that it added no real information of importance to the numbers and was no longer useful in its analysis.
  • MO measures real cash in circulation and in bank reserves.
  • MB, or money base, is the total supply of currency pus the stored portion of commercial bank reserves at the central bank. Both MO and MB are incorporated in M1 and M2.

The Federal Reserve releases the latest numbers on M1 and M2 money supplies on a weekly and monthly basis. The numbers are reported widely by the financial media and are published on the Fed's website.

What Are the Determinants of the Money Supply?

The big numbers of M1 or M2 contain a number of components that are analyzed by economists to determine just how all of that money is flowing through the system and where there might be problems. Economists speak of these components as the determinants of the money supply. They include:

  • The currency deposit ratio. That is, the amount of cash that the public at large is keeping on hand rather than depositing in banks.
  • The reserve ratio. This is the amount of cash that the Federal Reserve requires a bank to keep in its vaults to satisfy all potential withdrawals by its customers, even in the event of a run on the banks.
  • The excess reserve. This is the amount of money that the banks have available to lend out to businesses and individuals.

What Happens When the Federal Reserve Limits the Money Supply?

A country’s money supply has a significant effect on its macroeconomic profile, particularly in relation to interest rates, inflation, and the business cycle. In America, the Federal Reserve is responsible for the monetary supply. When the Fed limits the money supply via contractionary or "hawkish" monetary policy, interest rates rise and the cost of borrowing goes higher.

There is a delicate balance to these decisions. Limiting the money supply can slow down inflation, as the Fed intends. But there is also the risk that it will slow economic growth too much, leading to more unemployment.

How Is the Money Supply Determined?

A central bank regulates the amount of available in a country. Through monetary policy, a central bank can undertake an expansionary or contractionary policy.

  • An expansionary policy aims to increase the money supply. For example, the central bank might engage in open market operations. That means it will purchase short-term U.S. Treasury bills using newly-minted money. That money thus enters into circulation.
  • A contractionary policy would require selling Treasuries. That removes some of the money circulating in the economy.

What's the Difference Between M0, M1, and M2?

The U.S. money supply is reported in two main categories, M1 and M2. MO is included in both M1 and M2.

  • MO is the total amount of paper money and coins in circulation, plus the current amount of central bank reserves.
  • M1 is the most frequently reported headline number. It is MO plus money held in regular savings accounts and in travelers' checks.
  • M2 is all of M1 plus money invested in short-term assets that mature in less than a year, like some certificates of deposit.

Why Does the Money Supply Expand or Contract?

Consider a Main Street bank as a microcosm of the economy as a whole. Local people are prospering lately, so they have more money to save. They deposit it in the bank. The bank keeps part of the deposits in a vault but lends most of it out to other individuals and businesses. The loans are repaid with interest, and the bank has more money to loan. Times are good, and the money supply is increasing.

But what happens when times are not so good? Bank deposits fall because people are just getting by or, worse, losing their jobs. The bank has less money to lend. In any case, businesses and individuals shy away from big spending due to the poor economy. The money supply decreases.

The Bottom Line

The money supply may be one of the most tangible and understandable subjects in economics. It's a count of every bit of cash floating around the entire U.S. economy. Every dollar and every coin, down to the small change that people have in their pockets.

Analyzing the number is harder. Economists want to know precisely where that money is and how is it being used. Is it being hoarded or splurged? Invested or spent on day-to-day necessities?

The Federal Reserve considers the money supply in terms of potential action. Should it pump more money into the economy to encourage freer spending, investment, and job creation? Or should it pull back, slowing the flow of money through the system to avoid inflation?

The Federal Reserve releases its numbers on the money supply on the fourth Tuesday of every month, usually at 1 p.m. Eastern time.

I'm an economics enthusiast with a deep understanding of monetary policy and the intricacies of the financial system. My expertise stems from years of studying economic theory, analyzing real-world economic data, and staying abreast of developments in the field. I've also engaged in discussions with economists and financial professionals to broaden my knowledge and gain insights into various economic phenomena.

Now, let's delve into the concepts mentioned in the article "What Is the Money Supply?"

1. Money Supply: The money supply refers to the total amount of currency and other liquid assets circulating in an economy at a given point in time. It includes cash in circulation and various forms of bank deposits that can be readily converted into cash.

2. Federal Reserve (Fed): The Federal Reserve is the central banking system of the United States, responsible for conducting monetary policy, regulating banks, and maintaining financial stability. It tracks and influences the money supply through various policy tools.

3. Monetary Policy: Monetary policy refers to the actions undertaken by a central bank to control the money supply and achieve macroeconomic objectives such as price stability, full employment, and economic growth. The Fed uses tools like open market operations and changes in interest rates to influence the money supply.

4. M1 and M2 Money Supply: These are measures of the money supply tracked by the Federal Reserve. M1 includes currency in circulation and demand deposits (e.g., checking accounts), while M2 adds savings deposits and certain other liquid assets to M1.

5. Money Multiplier: The money multiplier is a concept related to the fractional reserve banking system, where banks can lend out a portion of the deposits they hold, thus creating new money in the economy. The multiplier effect amplifies the impact of changes in the monetary base on the broader money supply.

6. Determinants of the Money Supply: These are factors that influence the overall level of money supply in an economy. Key determinants include the currency deposit ratio (cash held by the public), reserve ratio (required reserves held by banks), and excess reserves (amount available for lending).

7. Inflation and Deflation: Changes in the money supply can impact price levels in the economy. An increase in the money supply may lead to inflation, while a decrease can result in deflation. Central banks aim to maintain price stability by managing the money supply.

8. Open Market Operations: Open market operations involve the buying and selling of government securities (e.g., Treasury bonds) by the central bank in the open market to influence the money supply and interest rates.

9. Expansionary and Contractionary Monetary Policy: These are policy stances adopted by central banks to either increase (expansionary) or decrease (contractionary) the money supply. Expansionary policies aim to stimulate economic activity, while contractionary policies aim to curb inflationary pressures.

10. Interest Rates: Changes in the money supply can affect interest rates in the economy. An increase in the money supply tends to lower interest rates, making borrowing cheaper and stimulating investment and spending.

By understanding these concepts and their interrelationships, economists and policymakers can analyze the dynamics of the money supply, predict its impact on the economy, and formulate appropriate monetary policies to achieve desired macroeconomic outcomes.

Money Supply Definition: Types and How It Affects the Economy (2024)

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