M2 money supply

What Is M2 Money Supply?

M2 money supply represents a broad measure of the total amount of money circulating within an economy, encompassing highly liquid assets that can be readily converted into cash. As a key concept within macroeconomics, M2 is one of several monetary aggregates tracked by central banks to assess the overall liquidity and financial health of an economy. It includes physical currency, checking deposits, and other less liquid forms of money such as savings deposits, money market accounts, and small-denomination time deposits.

History and Origin

The classification and measurement of money supply have evolved alongside the complexity of modern financial systems. In the United States, the Federal Reserve began formal tracking of various monetary aggregates to understand the economy's monetary dynamics. Initially, narrower measures like M1 were the primary focus, but as financial innovations emerged in the 1970s and early 1980s, M1's relationship with economic activity became less stable. This led to increased attention on M2, a broader and less interest-rate-sensitive aggregate that was created in 1980¹⁸.

The definition of M2 has undergone adjustments over time to reflect changes in how individuals and businesses hold money and conduct transactions. A significant redefinition occurred in May 2020 when the Federal Reserve Board announced changes to its H.6 Money Stock Measures release. These changes reflected the reclassification of savings deposits, which, due to regulatory amendments, were no longer subject to withdrawal limits and became similar to other transactional accounts, thus moving into the M1 aggregate. Consequently, M2's components were updated to reflect these shifts in the broader financial system¹⁷.

Key Takeaways

• M2 money supply is a broad measure of an economy's total money stock, including cash, checking deposits, and easily convertible "near money."
• It serves as a crucial indicator for policymakers and economists to gauge economic activity and potential inflationary pressures.
• The Federal Reserve regularly tracks M2, among other monetary aggregates, to inform its monetary policy decisions.
• Changes in M2 can offer insights into trends in consumer spending, investment, and overall economic growth.
• While M2 is widely used, its predictive power and relevance as an economic indicator have been subject to debate and criticism over time.

Formula and Calculation

The M2 money supply is calculated as the sum of M1 money supply and several other highly liquid assets. While not a "formula" in the sense of a mathematical equation with variables for prediction, it represents a defined aggregation of components:

Where:

• M1 includes physical currency in circulation, demand deposits (like checking accounts), and other liquid deposits (such as NOW and ATS accounts).
• Savings Deposits encompass funds held in savings accounts at depository institutions.
• Small-Denomination Time Deposits refer to certificates of deposit (CDs) and other time deposits typically under $100,000.
• Retail Money Market Mutual Funds include balances held in mutual funds that invest in short-term debt securities and are generally accessible by individual investors.

It is important to note that the exact composition of M2 can be subject to redefinition by central banks, as seen with the 2020 changes that shifted savings deposits from M2 to M1¹⁶.

Interpreting the M2 Money Supply

Interpreting the M2 money supply involves analyzing its growth rate and changes over time to infer underlying economic conditions and potential future trends. A rising M2 often suggests an increase in the amount of money available for spending and investment in the economy. This can be a sign of expanding economic activity and, if unchecked, could lead to inflation. Conversely, a slowing or contracting M2 might indicate a tightening of monetary conditions, potentially signaling a slowdown in economic growth.

Economists and policymakers at institutions like the Federal Reserve monitor M2 alongside other indicators, such as interest rates and Gross Domestic Product (GDP), to develop a comprehensive understanding of the economy. For instance, a rapid expansion of M2, if not accompanied by a corresponding increase in real output, could put upward pressure on prices¹⁵.

Hypothetical Example

Consider a hypothetical economy, "Econoville," where the central bank closely monitors its money supply. In January, Econoville's M2 money supply is $5 trillion. This includes $2 trillion in M1 (currency and checking accounts), $1.5 trillion in savings deposits, $0.8 trillion in small-denomination time deposits, and $0.7 trillion in retail money market funds.

Over the next six months, Econoville experiences robust economic growth. To support this growth, the central bank implements an expansionary monetary policy. As a result, commercial banks increase lending, and consumers deposit more funds into savings accounts and money market funds. By July, Econoville's M2 money supply has grown to $5.3 trillion. This increase reflects the greater availability of funds within the economy, stemming from a combination of new deposits and increased lending activity. This growth in M2 would signal to Econoville's central bank that there is more money circulating, which could further stimulate spending and investment.

Practical Applications

The M2 money supply is a significant indicator utilized by economists, analysts, and policymakers for several practical applications:

• Monetary Policy Formulation: Central banks, such as the Federal Reserve, routinely analyze M2 growth rates to inform their monetary policy decisions. Rapid M2 growth might prompt discussions about tightening monetary policy to prevent excessive inflation, while slow growth could suggest a need for more accommodative measures to stimulate economic activity¹⁴. For example, during the COVID-19 pandemic, M2 grew at record rates, influencing subsequent policy responses¹³.
• Inflation Forecasting: While the direct link has been debated, many economists believe that sustained rapid growth in M2 can be a precursor to inflationary pressures. Monitoring the M2 money supply helps in forecasting potential shifts in the purchasing power of currency¹².
• Economic Analysis and Prediction: Analysts use M2 as a component in various economic models to predict trends in GDP, consumer spending, and investment. It provides insight into the overall liquidity within the system, which can impact business cycles¹¹.
• Investment Strategy: Some investors and analysts monitor M2 trends for insights into market conditions. An expanding M2 might suggest increased liquidity potentially flowing into asset markets, while a contracting M2 could signal a more restrictive environment for asset prices¹⁰.

Limitations and Criticisms

Despite its widespread use, the M2 money supply is not without limitations and has faced various criticisms:

• Evolving Financial Landscape: Critics argue that M2, like other traditional monetary aggregates, may not fully capture the complexity of modern financial systems. The rise of new financial instruments, digital payment methods, and global capital flows can make it challenging for fixed definitions of money to accurately reflect economic liquidity⁹. The increasing ease of transferring funds between different account types can blur the lines between categories, sometimes making the M2 measure seem less precise⁸.
• Predictive Power Debate: The stability of the relationship between M2 and key economic variables like inflation and nominal GDP has varied over time, leading to debates about its reliability as a primary predictor. For instance, in the 1990s, M2's relationship with nominal GDP became less stable due to shifts in household financial behavior⁷. Some analyses suggest that M2's usefulness as an indicator of monetary policy impact on nominal expenditure depends on the predictability of its velocity⁶.
• Velocity of Money: M2 does not directly account for the velocity of money, which is the rate at which money changes hands in the economy. A high money supply with low velocity might have a different impact than a lower supply with high velocity. Some argue that without considering velocity, M2 provides an incomplete picture of monetary activity⁵.
• Policy Effectiveness: While central banks adjust interest rates and engage in activities like quantitative easing to influence the money supply, the direct controllability of M2 and its immediate structural relationship with economic activity are subjects of ongoing academic and policy discussion⁴.

M2 Money Supply vs. M1 Money Supply

The primary distinction between M2 money supply and M1 money supply lies in their scope of what constitutes "money." M1 is the narrowest measure, focusing on the most liquid forms of money directly used for transactions. It typically includes physical currency in circulation and demand deposits (e.g., checking accounts).

M2 is a broader aggregate that includes everything in M1, plus less liquid assets that are still relatively easy to convert into cash. These "near money" components include savings deposits, small-denomination time deposits (like Certificates of Deposit under $100,000), and balances in retail money market mutual funds. The confusion often arises because the components included in each aggregate can be redefined by central banks, as seen with the 2020 reclassification of savings deposits into M1. Essentially, M1 represents money that is immediately spendable, while M2 encompasses M1 plus funds that serve as a store of value but can be quickly accessed for spending.

FAQs

What does a high M2 money supply indicate?

A high or rapidly growing M2 money supply generally indicates that there is more money available in the economy for spending and investment. This can signal strong economic activity but may also raise concerns about potential inflation if the increase in money supply outpaces the growth in goods and services³.

How does the Federal Reserve use M2?

The Federal Reserve monitors M2 as one of several indicators to assess the overall health of the economy, gauge inflationary pressures, and inform its monetary policy decisions. It helps the central bank understand the availability of liquidity and the potential for shifts in economic activity.

Is M2 a reliable predictor of inflation?

The reliability of M2 as a direct predictor of inflation has been a subject of ongoing debate among economists. While historical data often show a correlation between M2 growth and inflation over the long run, especially in extreme cases, the relationship can be unstable in the short to medium term due to various factors, including changes in the velocity of money and financial innovation².

What are "small-denomination time deposits" in M2?

Small-denomination time deposits are a component of M2 money supply and typically refer to certificates of deposit (CDs) or other bank deposits that have a fixed maturity date and earn a fixed interest rate. They are generally considered "small" if they are less than $100,000¹. While less liquid than checking accounts, they can still be readily converted to cash.