Money is anything that is widely accepted as a method of payment. However, credit cards are not considered to be “money,” they are just a convenient loan. Stocks and bonds are also not accepted as payment. The Money Supply (MS) is the total cash in circulation and bank account deposits. Changes in the supply of money affect the rate of inflation, the exchange rate, and the business cycle.
How is the Money Supply Measured?
The supply of money is measured through monetary aggregates, usually classified as types of “M”s. They range from narrow to broad measures of the money supply.
Money Supply M1
Transactions money: This includes cash + checking + travelers checks + money orders
In the U.S. economy, M1 makes up roughly $1.4 trillion or 10% of GDP.
The most volatile monetary aggregate is the transfer from checking to saving.
Money Supply M2
This is M1 + savings account + individually held money market mutual funds (MMMFs), Money Market deposit accounts + small Certificate of Deposit (CD). M2 is a broader measure of money supply.
In the U.S. economy, M2 makes up roughly $7.5 trillion or 50% of GDP
Money Market Mutual Funds (MMMFs) – is the share price of a mutual fund. Regular mutual funds would buy commodities, stocks & bonds. An MMMF holds only money market asset like treasury bills, commercial papers (short-term loans).
For example, $100m from checking to MMMF
If M1 goes down by $100m, M2 remains the same as it contains M1.
Why is the Money Supply Important?
It affects variables like:
1. Price Level
The price level tends to be higher when MS levels increase.
2. Inflation
Higher MS growth rates tend to cause higher rates of inflation.
- Hyperinflation – very high rates of inflation, >50% /month
- Money demand – people’s demand for money for transactions and savings
3. Recession
Recessions are linked to steep declines in MS growth.