Money supply metrics

What Are Money Supply Metrics?

Money supply metrics are classifications used by economists and central banks to measure the total amount of money circulating within an economy. These metrics are a crucial component of macroeconomics, providing insights into the availability of liquidity and its potential impact on economic activity, inflation, and interest rates. The primary purpose of tracking money supply metrics is to understand and influence the overall financial landscape. Various measures, typically denoted as M0, M1, M2, and sometimes M3, categorize money based on its level of liquidity, from the most easily accessible forms to less liquid assets.

History and Origin

Historically, money supply concepts evolved as economies moved from commodity-backed currencies to modern fiat currency systems. In the United States, the Federal Reserve System, established in 1913, initially focused on preventing financial panics and ensuring the flow of credit. Over time, its role expanded to actively manage the growth of bank reserves and the money supply to promote a stable economy.

The definitions of money supply metrics have changed over the decades to reflect innovations in financial products and consumer behavior. For instance, the Federal Reserve has periodically revised its definitions of M1 and M2. A significant revision occurred in May 2020, when savings accounts were moved into the M1 category due to their increased liquidity and ease of transfer, leading to a substantial expansion of the M1 measure.²¹, ²², ²³ This adaptation highlights the ongoing effort by central banks to accurately capture the true measure of money in circulation.

Key Takeaways

• Money supply metrics quantify the total amount of money in an economy, categorized by liquidity levels (e.g., M0, M1, M2).
• These metrics are vital for policymakers to monitor and manage monetary policy, influencing inflation and economic growth.
• The Federal Reserve regularly publishes data on money supply, primarily M1 and M2, in its H.6 statistical release.
• Changes in money supply can impact purchasing power, investment, and the overall price level.
• Central banks utilize tools like reserve requirements, the discount rate, and open market operations to influence the money supply.

Formula and Calculation

While there isn't a single universal "formula" for the entire money supply, the various metrics (M0, M1, M2) are calculated by summing their constituent components. The composition of these components can vary by country, but they generally follow a hierarchy of liquidity.

For example, in the United States, the Federal Reserve defines its key money supply metrics as follows:

• Monetary Base (M0): Represents currency in circulation plus reserve balances held by depository financial institutions at Federal Reserve Banks.¹⁹, ²⁰

• M1: Consists of:

  • Currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions.¹⁷, ¹⁸
  • Demand deposits at commercial banks.¹⁶
  • Other liquid deposits, which include negotiable order of withdrawal (NOW) accounts, automatic transfer service (ATS) accounts, share draft accounts at credit unions, and, since May 2020, savings deposits.¹³, ¹⁴, ¹⁵

• M2: Encompasses all components of M1 plus:

  • Small-denomination time deposits (less than $100,000).¹¹, ¹²
  • Balances in retail money market funds.⁹, ¹⁰

The calculation of M2 can be expressed as:

It is important to note that the components are often seasonally adjusted by the Federal Reserve to remove regular seasonal patterns from the data, providing a clearer picture of underlying trends.⁸

Interpreting Money Supply Metrics

Interpreting money supply metrics involves understanding their relationship with economic variables such as inflation, output, and employment. A rising money supply, particularly in M1 and M2, generally suggests an expanding economy and increased liquidity, which can stimulate consumer spending and investment. Conversely, a contracting money supply may indicate a tightening of credit and a potential slowdown in economic activity.

Economists often look at the growth rate of different money supply measures. For instance, strong growth in M2 might signal future inflationary pressures if the supply of money outpaces the growth in goods and services. However, the direct link between money supply and inflation has become less predictable in recent decades due to factors like financial innovation and changes in the velocity of money. Policymakers at the Federal Open Market Committee (FOMC) review money supply data, but it is considered one of many indicators in their broader assessment of economic conditions.⁷

Hypothetical Example

Consider a hypothetical economy, "Diversiland," where the central bank monitors its money supply to manage economic stability.

Assume at the beginning of the year:

• Currency in circulation = $50 billion
• Demand deposits = $150 billion
• Savings accounts = $300 billion
• Small-denomination time deposits = $100 billion
• Retail money market funds = $75 billion

Based on the definitions:

• M1 = Currency + Demand Deposits + Savings Accounts = $50 billion + $150 billion + $300 billion = $500 billion.
• M2 = M1 + Small-denomination Time Deposits + Retail Money Market Funds = $500 billion + $100 billion + $75 billion = $675 billion.

Now, imagine the central bank implements a policy to stimulate the economy, such as lowering the reserve requirements for banks. This allows banks to lend more money, increasing the amount of demand deposits in the system. Suppose this leads to an increase in demand deposits by $20 billion and savings accounts by $10 billion.

The new money supply metrics would be:

• New Demand Deposits = $150 billion + $20 billion = $170 billion

• New Savings Accounts = $300 billion + $10 billion = $310 billion

• New M1 = $50 billion (currency) + $170 billion (new demand deposits) + $310 billion (new savings accounts) = $530 billion.

• New M2 = $530 billion (new M1) + $100 billion (time deposits) + $75 billion (money market funds) = $705 billion.

This hypothetical example illustrates how changes influenced by monetary policy can directly impact the calculated values of money supply metrics, reflecting the overall liquidity in the economy.

Practical Applications

Money supply metrics serve several practical applications for investors, economists, and policymakers:

• Monetary Policy Formulation: Central banks, such as the Federal Reserve, closely monitor money supply metrics when setting monetary policy. By analyzing trends in M1 and M2, they can gauge the effectiveness of their policies, such as adjusting interest rates or conducting open market operations, in influencing economic activity. The Federal Reserve Board's H.6 Money Stock Measures release provides detailed weekly and monthly data for these purposes.

• Inflation Forecasting: While not a perfect predictor, sustained rapid growth in money supply can signal potential inflationary pressures, as "too much money chasing too few goods" can lead to a rise in the general price level. Economists often incorporate money supply trends into their inflation models.

• Economic Analysis: Analysts use money supply data as an indicator of overall economic health and liquidity. A growing money supply typically supports economic expansion and job creation, while a contraction might precede a slowdown.

• Investment Decisions: Investors may consider money supply trends when making portfolio decisions. For instance, an expanding money supply might suggest a favorable environment for equities due to increased liquidity, while a contracting supply could lead to a more cautious approach.

• International Comparisons: Organizations like the International Monetary Fund (IMF) and the World Bank collect and publish money supply data for various countries, often focusing on broad money (M2). This allows for cross-country comparisons of financial systems and economic liquidity. The World Bank's Metadata Glossary for Broad Money provides a standardized definition frequently aligned with the IMF's "Money and quasi money" measure.

Limitations and Criticisms

Despite their importance, money supply metrics have several limitations and have faced criticisms, particularly regarding their reliability as primary targets for monetary policy:

• Unstable Relationship with Economic Activity: The direct correlation between money supply growth and key economic variables like gross domestic product or inflation has become less stable over time. Financial innovations, such as new payment technologies and investment vehicles, have blurred the lines between different forms of money and can cause shifts in how money is held and used, making the aggregates less predictable.⁵, ⁶

• Velocity of Money: The velocity of money, which is the rate at which money changes hands in the economy, can be volatile. If money supply increases but its velocity decreases, the impact on economic activity and the price level might be muted, undermining the predictive power of money supply metrics.³, ⁴

• Challenges in Control: Central banks face challenges in precisely controlling the money supply. While they can influence it through tools like open market operations and the discount rate, the actual amount of money in circulation is also affected by the lending decisions of financial institutions and the public's demand for money.²

• Data Revisions and Definitions: Money supply definitions are subject to periodic revisions, as seen with the Federal Reserve's reclassification of savings deposits into M1 in 2020.¹ Such changes can make historical comparisons difficult and require economists to adjust their models.

• Policy Debate: There has been an ongoing debate among economists regarding the effectiveness of money supply targeting. Some argue that focusing solely on money supply can lead to unintended consequences, and that central banks should instead prioritize other indicators like interest rates or inflation targets. The paper "Is money supply targeting obsolete?" discusses these objections.

Money Supply Metrics vs. Inflation

While closely related, money supply metrics and inflation are distinct concepts that describe different aspects of an economy. Money supply metrics quantify the total amount of money available in an economy at a given time, categorized by liquidity. Inflation, on the other hand, is the rate at which the general price level of goods and services is rising, and consequently, the purchasing power of currency is falling.

The common confusion arises from the Quantity Theory of Money, which posits a direct relationship between the money supply and the price level, assuming constant velocity and real output. Historically, central banks often targeted money supply growth to control inflation. However, in modern economies, the relationship has become less direct. An increase in the money supply does not automatically lead to inflation, especially if the economy has significant unused capacity, or if the velocity of money declines. Conversely, inflation can occur due to factors unrelated to money supply, such as supply chain disruptions or increased demand. Therefore, while money supply trends are an important input for assessing inflationary risks, they are not the sole determinant of inflation.

FAQs

What are the main types of money supply metrics?

The main types of money supply metrics typically include M0 (the monetary base), M1 (most liquid forms like currency and demand deposits), and M2 (M1 plus less liquid assets like savings accounts and money market funds). Some countries might also track M3, a broader measure.

Who is responsible for measuring money supply?

In the United States, the Federal Reserve Board is responsible for measuring and reporting money supply data. Other countries have their respective central banks or national statistical agencies that fulfill this role. Data for the U.S. money supply is publicly available through the Federal Reserve Board's FAQ on Money Supply and its H.6 statistical release.

Why do money supply definitions change?

Money supply definitions change to adapt to the evolving financial landscape and how people hold and use money. As new financial products emerge and payment methods become more sophisticated, central banks revise their definitions to ensure the metrics accurately reflect the current state of monetary liquidity in the economy. This helps policymakers make more informed decisions about monetary policy.