M2

What Is M2?

M2 represents a broad measure of the money supply within an economy, encompassing highly liquid financial assets that are readily convertible to cash. This monetary aggregate is a key concept in Monetary Economics and is tracked by central banks, such as the Federal Reserve in the United States, to monitor economic activity. M2 includes all components of M1—which consists of physical Currency in Circulation, Demand Deposits (checking accounts), and other liquid deposits—plus less liquid assets like Savings Accounts, small-denomination Time Deposits (certificates of deposit under $100,000), and retail Money Market Funds.

##¹⁷ History and Origin

The concept of measuring money supply, including aggregates like M2, evolved as central banks and economists sought to understand the quantity of money available in an economy and its potential impact on prices and output. The Federal Reserve, as the Central Bank of the United States, has historically defined and tracked various monetary aggregates (M0, M1, M2, and M3). These definitions have been refined over time to reflect changes in banking practices and financial innovations.

A significant redefinition of M1 and M2 occurred in May 2020. Prior to this, savings deposits were a component of M2 but were not included in M1. The Federal Reserve's H.6 Money Stock Measures release announced a regulatory amendment that led to the reclassification of savings deposits as part of M1 due to their increased transactional nature. Consequently, the definition of M2 shifted to include the newly defined M1 plus small-denomination time deposits and retail money market funds, excluding Individual Retirement Account (IRA) and Keogh balances. Thi¹⁶s adjustment aimed to more accurately reflect the Liquidity of various financial instruments in the modern financial landscape.

Key Takeaways

• M2 is a measure of the money supply that includes M1 (currency, checking accounts, and other liquid deposits) plus small-denomination time deposits and retail money market funds.
• ¹⁵ Central banks, like the Federal Reserve, track M2 to assess the overall amount of money circulating in the economy.
• Changes in M2 can offer insights into potential Inflation or deflationary pressures, as well as the pace of Economic Growth.
• The composition of M2 has been periodically redefined by monetary authorities to adapt to evolving financial systems.
• ¹⁴ M2 serves as an important indicator for policymakers when formulating Monetary Policy decisions.

Formula and Calculation

The calculation of M2 involves summing its constituent parts. While the Federal Reserve provides detailed data, the general formula for M2 is:

Where:

• M1 includes currency in circulation, demand deposits, and other liquid deposits.
• ¹³ Small-denomination time deposits are typically certificates of deposit (CDs) with balances less than $100,000. The¹²se are less liquid than checking accounts because they have a fixed maturity period and often penalties for early withdrawal.
• Retail money market funds are investment funds that invest in short-term, highly liquid securities, allowing investors to earn market-based rates of interest.

It¹¹ is important to note that certain balances, specifically IRA and Keogh balances held at depository institutions and money market funds, are excluded from both small-denomination time deposits and retail money market funds when calculating M2.

##¹⁰ Interpreting M2

Interpreting M2 involves understanding its implications for the broader economy. A growing M2 supply can indicate an increase in the amount of money available for spending and investment, which may stimulate economic activity. Conversely, a rapidly expanding M2 might signal potential inflationary pressures if the supply of money grows faster than the production of goods and services.

Economists and policymakers analyze trends in M2 alongside other economic indicators to gauge the health and direction of the economy. For instance, during periods of economic uncertainty, consumers and businesses might hold more cash or shift funds into more liquid assets included in M2. Conversely, during strong economic times, money might flow into less liquid investments. Analyzing these shifts can provide insights into consumer and business confidence. The Federal Reserve Board regularly releases data on M2, which analysts use to assess current economic conditions and anticipate future trends.

##⁹ Hypothetical Example

Consider a hypothetical economy where the central bank is monitoring its money supply.

Suppose the following components are observed:

• Currency in circulation = $2,000 billion
• Demand deposits = $10,000 billion
• Other liquid deposits (e.g., negotiable order of withdrawal (NOW) accounts, automatic transfer service (ATS) accounts) = $5,000 billion
• Small-denomination time deposits = $1,500 billion
• Retail money market funds = $1,200 billion

First, we calculate M1:
M1 = Currency in circulation + Demand deposits + Other liquid deposits
M1 = $2,000 billion + $10,000 billion + $5,000 billion = $17,000 billion

Next, we calculate M2 using the M1 figure:
M2 = M1 + Small-denomination time deposits + Retail money market funds
M2 = $17,000 billion + $1,500 billion + $1,200 billion = $19,700 billion

In this scenario, the total M2 money supply for the economy is $19,700 billion. The central bank would track this figure over time to observe its growth rate and potential implications for Interest Rates and the overall economy.

Practical Applications

M2 plays a crucial role in various aspects of financial analysis and policy.

• Monetary Policy Formulation: Central banks closely monitor M2 as an indicator of the overall liquidity in the financial system. Changes in M2 can influence decisions related to Open Market Operations, the federal funds rate, and other tools used to manage the money supply and achieve objectives like price stability and maximum employment. For example, during periods when the Federal Reserve implemented policies like Quantitative Easing, large-scale asset purchases were intended to increase the money supply, which would typically be reflected in a rising M2.
• Inflation Forecasting: While the direct link between M2 growth and inflation has been debated, many economists still consider M2 a relevant factor in predicting future price changes. Rapid and sustained growth in M2 that outpaces the growth in an economy's productive capacity can suggest an increased risk of inflation.
• Economic Analysis: Analysts use M2 data to assess the health and momentum of an economy. A shrinking M2 might signal a slowdown in economic activity or a shift in investor behavior towards less liquid assets, potentially indicating a coming Recession.
• Academic Research: Economists conduct extensive research on the relationship between M2, nominal GDP, and inflation. The velocity of M2 money stock, which measures the rate at which money is exchanged in an economy, is another key metric often analyzed in conjunction with M2 data. Data on M2 is publicly available from sources like the Federal Reserve Bank of St. Louis's FRED database, which offers historical series for M2 and its components.

##⁸ Limitations and Criticisms

While M2 is a widely used measure, it is not without limitations or criticisms. One primary challenge is that the relationship between M2 and key economic variables like inflation or economic growth is not always consistent or predictable. Changes in financial innovation, consumer behavior, and global capital flows can alter how M2 behaves. For example, the increasing ease of transferring funds between different types of accounts can blur the lines between what is considered highly liquid and less liquid, making the precise demarcation of M2 somewhat arbitrary.

Fu⁷rthermore, the predictive power of M2 for inflation has been a subject of ongoing debate among economists. While classical monetary theory suggests a strong link, empirical evidence in recent decades has shown that this relationship can be less direct, particularly in modern economies with sophisticated financial markets and diverse investment opportunities. Some critics argue that focusing too heavily on M2 can lead to misinterpretations of economic conditions, as other factors, such as supply-side shocks or changes in aggregate demand, can also significantly influence inflation.

Despite these criticisms, M2 remains a standard measure used by monetary authorities. The Federal Reserve continues to publish M2 data weekly as part of its H.6 release, recognizing its role in providing insight into the overall money supply.

##⁶ M2 vs. M1

The distinction between M2 and M1 is crucial for understanding the hierarchy of money supply measures. M1 represents the narrowest and most liquid measure of the money supply, encompassing assets that can be most easily converted into cash and used for transactions. It primarily includes physical currency in circulation and various types of checking accounts (demand deposits, NOW accounts, ATS accounts).

M2⁵, on the other hand, is a broader monetary aggregate that includes all components of M1, plus additional assets that are considered highly liquid but are not typically used for daily transactions. These include small-denomination time deposits (like certificates of deposit under $100,000) and retail money market funds. The⁴ key difference lies in the degree of liquidity and the primary use of the assets. While M1 assets are primarily used as a medium of exchange, the additional components of M2 generally serve more as a store of value that can be readily accessed if needed. The³ Federal Reserve redefined the components of M1 and M2 in May 2020, most notably by including savings deposits in M1, which previously were only part of M2.

##² FAQs

What does it mean if M2 is increasing rapidly?

A rapid increase in M2 generally means there is more money circulating in the economy. This could be a result of central bank policies, increased lending by banks, or a shift in funds from less liquid assets into M2 components. While it can signal stronger economic activity, sustained rapid growth in M2, if not matched by an increase in goods and services, could contribute to Inflation.

Who tracks M2?

In the United States, the Federal Reserve tracks and publishes data on M2. This data is released weekly as part of the H.6 Money Stock Measures report and is widely used by economists, financial analysts, and policymakers.

##¹# Is M2 a good indicator of inflation?
The relationship between M2 and inflation has varied over time. Historically, a strong link was observed, but in modern economies, this connection can be less direct due to various factors like financial innovation and changes in how money is used. While M2 growth is still monitored for inflationary signals, economists also consider a wide range of other indicators when forecasting inflation.

How does M2 affect average consumers?

Changes in M2 can indirectly affect average consumers through its influence on the broader economy. For instance, if a rapidly growing M2 contributes to inflation, consumers might experience a decrease in purchasing power. Conversely, policies aimed at increasing M2, such as Quantitative Easing, might lead to lower Interest Rates on loans, potentially benefiting consumers who borrow money.

What is the primary purpose of tracking M2?

The primary purpose of tracking M2 is to provide insights into the overall availability of liquid money in the economy. This information is critical for central banks in formulating and implementing Monetary Policy, such as setting interest rates, to achieve macroeconomic objectives like price stability and sustainable Economic Growth.