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Measures of Money Supply

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Measures of Money Supply

What happens when the money supply in the economy increases? How to find out whether there is more money in the economy than there was a year ago? What are some of the Fed's methods to measure the money supply in the U.S. economy? You will be able to answer all these questions once you read our article on Measuring Money Supply. Stay tuned!

Measures of money supply meaning

Thousands of years ago, humans used a barter system to trade goods and services. Economic health and performance were directly measured in goods and services, which could be problematic. Disputes could occur over the quantity and quality of goods, and barter could involve time-consuming haggling. The stresses and time consumption of barter meant that it had high transaction costs. Fortunately, humans quickly began utilizing various forms of money to trade for goods and services as a medium of exchange. This lowered transaction costs significantly.

Today, instead of measuring often-subjective values of goods and services, we can objectively measure economic performance and growth through the money supply. The money supply value reveals how much spending (demand) and production (supply) can be generated. One goal of economists and those in the finance (banking and lending) industry is to accurately measure the money supply to determine economic health and potential economic growth rates. They want to know how much money is available for spending right now and how much there may be available in the future.

Measuring the money supply means calculating the total stock of money in the economy at a particular time.

Methods of money supply measurement

Methods used to measure the money supply include: M0, M1, and M2. M0 is the monetary base and includes currency in circulation and the bank reserves. M1 and M2 methods of measuring the money supply are more common. They provide a more comprehensive measurement of the money supply by including other forms of money such as demand deposits, traveler's checks, and near-money assets.

The first two measures of the money supply, M0 and M1, are the most liquid. M0, the monetary base, represents the amount of money that can be instantly used to increase the level of loanable funds in commercial banks. Depositors could deposit their currency in savings accounts or time deposits, and banks could withdraw their reserves from the Fed. This money could be loaned to borrowers immediately. M1 represents the number of funds that can be directly spent to stimulate the economy (aggregate demand). Consumers can pay using cash, checks, or debit cards without withdrawing money from banks first.

To learn more about the money supply and the loanable funds market check our explanation on - The Loanable Funds Market

The other measure of the money supply - M2 consists of near-monies that will become demand deposits upon maturity and can be withdrawn in full, either as cash or transferred to checkable deposits. These vary in liquidity, with maturity on CDs ranging from three months to five years. Less liquidity (more extended time to maturity) provides depositors with greater interest rates.

The Federal Reserve currently tracks M0, M1, and M2.

Measures of Money Supply, M2 Money Supply, StudySmarterFigure 1. M2 money supply - StudySmarter. Source: Federal Reserve Economic Data1

Using data from the St. Louis Federal Reserve Bank in Figure 1, we can see the amount of M2 money in the economy has been growing, especially during the pandemic. One of the main reasons for the increase in the M2 money supply is the decrease in interest rates. After the pandemic hit the U.S. economy, the Fed decided to lower the interest rate and pursue an expansionary policy to prevent the economic crisis from deteriorating.

Money supply measurement formula

Methods used to measure the money supply include: M0, M1, and M2 and they have their corresponding formulas.

M0, also denoted as MB, is the monetary base. It is calculated as:

M1 consists of money that can be spent immediately, and is the most liquid form of money:

M2 consists of M1 plus near-moneys that can be converted to cash quickly if needed. It also includes money market funds (mutual funds that invest only in liquid assets):

Importance of measuring money supply

Not knowing the current money supply places the economy at risk of inflation (too much money) or recession (too little money). That is why policymakers and bankers want to ensure sufficient liquidity in the market to cover the demand for funds.

Knowing the current money supply lets the government adjust it through monetary policy. If the money supply is too low to sustain healthy growth, which puts the economy at risk of a recession, the Fed can use monetary policy to increase it. Conversely, if the money supply is too high, then to limit inflation, the Fed can use monetary policy to decrease the money supply. However, the Fed would not be able to choose the right policy if data on the amount of money circulating in the U.S. economy did not exist.

Based on the reserve ratio, which is the per cent of deposits that banks must keep in the form of cash, policymakers can determine how much the money supply could increase if all excess reserves (deposits that can be loaned, as opposed to required reserves, which must be kept in the form of cash) were loaned. Thus, the current money supply reveals how much spending could occur immediately and how much could occur if all near-monies were loaned at the maximum allowable extent (until excess reserves were zero).

At the time of writing this article, the M2 money supply in the U.S. has reached high levels. This was also associated with an increase in inflation in the U.S., reaching 8.5%, the highest since 1981.2 The data on the money supply, which is available due to different methods of money supply measurement, helps the U.S government and the Fed navigate the economy further by coming up with policies that address inflation without significantly harming the economic growth of the U.S.

Challenges affecting the measurement of money supply

Accurately measuring the money supply can be difficult, as money exists in physical and electronic forms. Additionally, the type of financial assets has evolved, and new financial products are being developed every day.

Due to the ability of banks to lend money from deposits, one challenge of measuring the money supply is the risk of double counting or counting the same value more than once. To prevent such accounting errors, banks use balance sheets. Ensuring that all new deposits and loans are accounted for as both liabilities (something that is owed) and assets (something that is owned) makes it unlikely that banks will accidentally lend too much. Banks are regulated and audited (have their records checked) by both state and federal agencies, including the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC).

Another challenge in measuring the money supply is the prevalence of assets and securities (investments like stocks and bonds) similar to money but are not legal tender (accepted by law as payment). U.S. Treasury bonds may seem similar to cash but are not part of the money supply. Similarly, shares of stock, even though they may be quickly bought and sold electronically, are not part of the money supply. Other investments like gold and cryptocurrency, though they may look like money and even be used to buy goods and services, are not technically money. Gold and silver bullion coins, often sold as one pure ounce, may resemble U.S. currency but are not legal tender if the U.S. Mint does not mint them. Similarly, cryptocurrencies like Bitcoin and Ethereum are not actual U.S. currencies. All of this makes it harder to measure the actual money supply in the economy.

A final complication comes in measuring different components of the money supply, which can often be confusing.

  • M0, also known as the monetary base, consists of all currency in the hands of the public and commercial bank reserves held at the nation’s central bank (for the U.S. this is one of the twelve regional Federal Reserve banks). M0 represents money that could be deposited in commercial banks and loaned; thus, it is the amount that could immediately increase the money supply.
  • M1 consists of currency and checkable deposits, meaning it includes part of M0 that is only cash. Therefore not all of M0 is included in M1 because the bank reserves held at the Fed are excluded.
  • M2 adds the near-moneys such as savings accounts, CDs, and money market funds (MMFs) to M1.

In addition to having three separate components of the total money supply, money can move from one component to another. For example, a cash withdrawal from a savings account moves money from M2 to M1 and vice versa. All this makes the money measurement more complicated.

Measures of Money Supply - Key takeaways

  • Measuring the money supply means calculating the total stock of money in the economy at a particular time.
  • Methods used to measure the money supply include M0, M1, and M2.
  • M0, also known as the monetary base, consists of all currency in the hands of the public and commercial bank reserves held at the nation’s central bank.
  • M1 consists of currency and checkable deposits, meaning it includes part of M0 that is cash.
  • M2 adds the near-monies such as savings accounts, CDs, and money market funds (mutual funds that invest only in liquid assets) to M1.
  • Not knowing the current money supply places the economy at risk of inflation (too much money) or recession (too little money).

Sources:

1. Federal Reserve Economic Data - M2 Data Chart, 2022

2. POLITICO - U.S. inflation jumped 8.5 percent in past year, highest since 1981, 2022


Frequently Asked Questions about Measures of Money Supply

Measuring the money supply means calculating the total stock of money in the economy at a particular time.

Not knowing the current money supply places the economy at risk of inflation (too much money) or recession (too little money).

Knowing the current money supply lets the government adjust it through monetary policy. If the money supply is too low to sustain healthy growth, which puts the economy at risk of recession, the Fed can use monetary policy to increase it.

Methods used to measure the money supply include M0, M1, and M2.

M1 and M2.

Final Measures of Money Supply Quiz

Question

What is money supply measurement?

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Answer

Measuring the money supply means calculating the total stock of money in the economy at a particular time.

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Question

Why is measuring money supply important?

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Answer

Not knowing the current money supply places the economy at risk of inflation (too much money) or recession (too little money).

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Question

What is the advantage of measuring the supply money?


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Answer

Knowing the current money supply lets the government adjust it through monetary policy. If the money supply is too low to sustain healthy growth, which puts the economy at risk of recession, the Fed can use monetary policy to increase it.

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Question

How is money supply measured?


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Answer

Methods used to measure the money supply include M0, M1, and M2.

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Question

What are the most common money supply measurements?


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Answer

M1 and M2

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Question

What is the purpose of measuring the money supply?

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Answer

One goal of economists and those in the finance (banking and lending) industry is to accurately measure the money supply to determine economic health and potential economic growth rates. 

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Question

What is M0?

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Answer

M0 is the monetary base and includes currency in circulation and bank reserves.

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What are the most liquid methods of money supply measurement?

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Answer

 M0 and M1 are the most liquid.

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Question

Why has the M2 money supply increased in the US economy?

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Answer

One of the main reasons for the increase in the M2 money supply is the decrease in interest rate.

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Question

Explain M1 money supply.

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Answer

M1 consists of currency and checkable deposits, meaning it includes part of M0 (cash), but not all as some bank reserves are held at the Fed

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Question

Explain M2 money supply.

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Answer

M2 adds the near-moneys such as savings accounts, CDs, and money market mutual funds (MMMFs) to M1. 

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Question

Explain M3 money supply.

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Answer

M3, a component of the money supply that is not used much today, consists of M2 plus very large CDs - over $100,000 in value - and other, less liquid financial assets.

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Question

What are some of the challenges of measuring the money supply?

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Answer

Challenge in measuring the money supply is the prevalence of assets and securities (investments like stocks and bonds) similar to money but are not legal tender (accepted by law as payment). 

Another challenge comes in measuring components of the money supply, which can often be confusing. Money can move from one component to another. For example, a cash withdrawal from a savings account moves money from M2 to M1 and vice versa. All this makes the money measurement more complicated.


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