Indicator 3 – Money Supply

27 Jun

In previous posts I have alluded to the fact that the Federal Reserve (“The Fed”) uses data such as the real GDP, CCI and other related economic indicators to adjust monetary policy.  Therefore, this post is dedicated to defining what is meant by the “money supply” and the methods The Fed uses to regulate it.

The money supply is broken down into aggregates:

M0:  Physical currency. A measure of the money supply which combines any liquid or cash assets held within a central bank and the amount of physical currency circulating in the economy. M0 (M-zero) is the most liquid measure of the money supply. It only includes cash or assets that could quickly be converted into currency. This measure is known as narrow money because it is the smallest measure of the money supply.

M1:  M0 + demand deposits, which are checking accounts. This is used as a measurement for economists trying to quantify the amount of money in circulation. The M1 is a very liquid measure of the money supply, as it contains cash and assets that can quickly be converted to currency.

M2:  M1 + small time deposits (less than $100,000), savings deposits, and non-institutional money-market funds. M2 is a broader classification of money than M1. Economists use M2 when looking to quantify the amount of money in circulation and trying to explain different economic monetary conditions – M2 is a key economic indicator used to forecast inflation.

M3:  M2 + all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets. The broadest measure of money; it is used by economists to estimate the entire supply of money within an economy.  The Federal Reserve previously published data on three monetary aggregates (M1, M2 and M3), but ceased publication of M3 in the spring of 2006.

Some economists believe that M2’s relevancy has waned over the past 20 years.  For many years this monetary measurement closely paralleled the growth or contraction of the U.S. economy and overall changes in prices.  Over the past two decades, however, a bevy of changes including the introduction of new depository products, the movement of consumer funds from bank deposits to investment accounts and the internationalization of the economy has caused the money supply data to fall out of sync with other economic indicators.

Nevertheless, the Federal Reserve and some economists and analysts pay attention to the longer-term trends in growth or reduction of the money supply, particularly the six-month figures.  And the Federal Reserve retains its power to increase the money supply – the three ways that it does this are: 1) through changing the required reserve ratio (the amount banks must hold in reserve as a percentage of demand deposits), 2) allowing banks to borrow from it (The Fed) at the discount rate, and 3) conducting open market operations (buying and selling bonds).

In short, The Fed controls the money supply in the U.S. by controlling the amount of loans made by commercial banks.  New loans are usually in the form of increased checking account balances, and since checkable deposits are part of the money supply, the money supply increases when new loans are made and decreases when loans decrease.

A brief analysis of this indicator raises more topics for further analysis:

1.  What are the implications of a fiat currency system (i.e. a currency system which has no intrinsic value and cannot be redeemed for specie or any commodity, but is made legal tender through government decree) on the money supply and the economy?

2.  What impact has the explosion in credit (which is not included in the money supply) had on the economy?

3.   What are the implications of flat-lined M0 and M1 (money outside the banking system) compared to an explosion of M2 and M3 money supply within the banking system?

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