What Is the Money Supply, and How Does It Affect the Economy?

Question: What Is the Money Supply, and How Does It Affect the Economy?

Answer: The money supply as defined by the Federal Reserve, the nation's central bank, is very narrowly defined. It includes cash, checks and savings held at banks. However, when many people speak of the money supply, they are referring to all forms of cash, credit and wealth that can be used to purchase goods and services, including investments. In recent years, credit has become the most important component of the money supply, far outweighing any cash on hand or savings in the bank.

How Is the Official Money Supply Measured?

The Federal Reserve, has two main measurements of the U.S. money supply. The Fed reports on these measures every week. They are M1, which is the most liquid form of money and M2, which is a little more difficult to spend. Specifically:

• M1 includes currency, travelers checks, and checking account deposits. It also includes those checking accounts that pay interest, even though many people use them as savings accounts.
• M2 includes everything in M1 plus savings accounts, time deposits under $100,000, and money market mutual funds (except those held in IRAs).

Neither M1 nor M2 measures the amount of money invested in stock or bond funds, which most people now use for investments rather than just savings accounts. In fact, during the 1990s money supply as measured by M2 fell as people took money out of low-interest bearing savings account and invested in the stock market. In fact, then-Federal Reserve Chairman Alan Greenspan said that, if the economy were dependent on the M2 money supply for growth, it would be in a recession.

These money supply measurements also don't count home equity, which was a major source of cash for many people in mid-2000s. For all these reasons, these money supply measurements are not really good indicators for tracking the total wealth in the economy. In fact, the Federal Reserve no longer sets a target for the money supply.(Source: Federal Reserve Bank of New York, The Money Supply)

What Is the Money Supply?

In April 2008, M1 was $1.4 trillion and M2 was $7.7 trillion (after taking out the effects of regular seasonal changes). The Federal Reserve reported that half of M1 was cash and currency. Of this cash, an astonishing two-thirds was held outside of the country. However, as many travelers know, a $20 bill is good throughout the world. As for M2, half was savings accounts. Both measures were 6% higher than the year before, despite the 2008 financial crisis.

By the end of 2009, the M1 money supply continued to grow to $1.7 trillion, while M2 was $8.5 trillion. This was despite the worst recession since the Great Depression. A year later, M1 was $1.8 trillion, and M2 $8.8 trillion. As of December 2011, the money supply was still expanding. M1 has ballooned to $2.2 trillion, while M2 was $9.6 trillion. This made sense, as Americans started saving more in response to recessionary fears.(Source: Federal Reserve, Money Stock Measures)

What About the Loose Definition of the Money Supply?

Many analysts worry that the Federal Reserve's efforts to add liquidity to world's financial system is increasing the money supply, and will bring a return of inflation. They are particularly concerned about the Fed's quantitative easing program, where it buys Federal Treasury notes and mortgage-backed securities in an effort to keep interest rates down. (Source: The Economist, Money Supply, August 6, 2011; Forbes, Obama's Love Hate Relationship With Ben Bernanke, March 22, 2012)