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 treasuries, or a combination of both. 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 account balances, circulating in an economy at a given point in time.
- Variations in the money supply 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 view the money supply as the main driver of demand in an economy and believe that increasing the money supply faster than the increase in real income leads to inflation.
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Understanding the 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 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 tools it can use to keep the economy growing at a reasonable pace.
- It controls interest rates by setting the key rates it charges to the nation's banks for overnight loans of government money. 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 weaknesses. The Fed generally refers to the money supply as the money stock in its public releases.
$18.06 trillion
As of June 2024, the seasonally adjusted M1 money supply according to the Federal Reserve.
Effect of the Money Supply on the Economy
An increase in the supply of money typically lowers interest rates, which 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 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 many economic measures that economists and the Federal Reserve collect, track, and review.
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.
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 was yet another number, M3, but its reporting was discontinued by the Fed in 2006.
There are also M0 and MB, but these are generally included in the main categories rather than being reported separately.
All of the categories account for the amount of cash in the economy, but each category has a slightly different definition of cash or liquid assets.
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 a bank teller's drawer, plus other money equivalents that can be converted easily to cash.
For example, a regular bank savings account is a money equivalent. The account holder can convert those savings to cash at any time and instantly.
M2
M2 includes M1 plus short-term time deposits in banks and money market funds. Generally, terms of less than a year are considered short-term.
M3, M0, and MB
M3, M0, and 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.
- M0 measures real cash in circulation and bank reserves.
- MB, or money base, is the total supply of currency plus the stored portion of commercial bank reserves at the central bank. Both M0 and MB are incorporated in M1 and M2.
The Federal Reserve releases the latest numbers on M1 and M2 money supplies weekly and monthly. 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 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: This is the amount of cash that the public at large is keeping on hand rather than depositing in banks.
- 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.
- 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. 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 consider when undertaking 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 money 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. M0 is included in both M1 and M2.
- M0 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 M0 plus money held in regular savings accounts and 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 it is being used. Is it being hoarded or splurged? Invested or spent on day-to-day necessities? The Federal Reserve considers the money supply when evaluating what kind of monetary policy to enact.
