Measures of Money Supply

What is Money Supply Measurement?

Money supply measurement is a method used by economists and policymakers to quantify and categorize the total amount of monetary assets available in an economy at a particular time. It involves various classifications of money, including physical currency and different types of bank deposits, categorized into aggregates such as M0, M1, M2, and M3 based on their liquidity and accessibility for use in transactions.

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 stress and time consumption of barter meant 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.

How is Money Supply Measured?

Methods used to measure the money supply include: M0, M1, and M2. These aggregates represent different degrees of 'liquidity' - or how easily a certain type of money can be used for transactions. 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 Federal Reserve currently tracks M0, M1, and M2.

Let's look at each of these in more detail.

M0 Measure of Money Supply - Base Money

M0, also known as base money, is the most liquid form of money. It consists of physical currency (notes and coins) in circulation and reserves held by financial institutions at the central bank. This is the foundation of a country's money supply and represents money that is readily available for transactions and spending.

M1 Measure of Money Supply - Narrow Money

M1, often referred to as 'narrow money', includes M0 plus all demand deposits and other checkable deposits. These are funds in bank accounts that can be accessed easily and used for transactions directly, such as checking accounts. M1 thus represents currency in circulation plus immediate-access bank balances - a slightly broader view of the available money supply.

M2 Measure Money Supply - Broad Money

M2, or 'broad money', includes everything in M1 plus other less liquid types of money. These less liquid forms include savings accounts, small denomination time deposits (deposits with a fixed term), and money market mutual funds. While these types of money can't be spent as directly as cash or checking account balances, they can usually be converted into cash relatively easily.

M3 Measure Money Supply - Large Time Deposits

M3 is the broadest classification of money. It includes all components in M2 plus large time deposits, institutional money market funds, short-term repurchase agreements, and other larger liquid assets. These forms of money are less liquid than those included in M2, meaning they can't be converted into cash as quickly or easily.

By understanding these money aggregates, you can get a clearer picture of the depth and liquidity of a country's money supply. Each category provides a unique perspective on economic stability and monetary policy effectiveness.

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:

\(M0=\text{Currency in circulation}+\text{Bank reserves}\)

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

\(M1=\text{Currency in circulation}+\text{Checkable bank deposits}+\text{Traveler's checks}\)

M2 consists of M1 plus near-moneys that can be converted to cash quickly if needed, such as saving accounts and certificates of deposit (CDs). It also includes money market funds (MMFs, mutual funds that invest only in liquid assets):

\(M2=M1+\text{Near-moneys (saving accounts, CDs)}+\text{MMFs}\)

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.