M2 Money Supply: Definition, Calculation, Impact on the Economy

UTC by John Caroline · 7 min read
M2 Money Supply: Definition, Calculation, Impact on the Economy
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In the following guide, we’ll talk about the M2 money supply since it is an important measure of the amount of money available for spending and investment in the economy.

Economists use liquidity as the basis for defining money more broadly, rather than relying on a single measurement. Liquidity is determined by how easily a financial asset can be converted into cash for the purpose of purchasing goods or services. While cash is highly liquid, other forms of payment such as checks or credit cards may be less so. For example, $10 in cash can be easily used to buy lunch, whereas the same amount held in a savings account would require a trip to the bank or an ATM to withdraw the funds, making it less liquid.

This brings us to discussing the measurement of the broader form of money. In particular, we will talk about the M2 money supply. Basically, the M2 money supply is a broader measure of the money supply that includes components beyond the most liquid forms of money. M2 includes savings deposits, time deposits, and money market mutual funds.

Notably, the concept of liquidity is important in defining what constitutes money in M2. Liquidity refers to how quickly a financial asset can be used to buy a good or service. While cash is very liquid, financial assets in savings accounts or other less liquid forms are not as easily used. These less liquid forms of money are still considered part of the broader M2 money supply, but they are not as easily accessible as cash in hand.

Money Supply Defined

Money supply refers to the total amount of money that is circulating in a country’s economy at a given time. It includes all forms of money, such as cash, bank deposits, and other financial assets that can be used as a means of exchange.

The money supply can be measured in various ways, including M1, M2, and M3, which represent different types of money and financial assets that are included in the overall measure.

Furthermore, changes in the money supply can have a significant impact on the economy, including inflation or deflation, interest rates, and economic growth. As such, monitoring and managing the money supply is an important task for central banks and governments.

M2 Money Supply Explained

As said earlier, the M2 money supply is a measure of the total amount of money circulating in an economy. It is broader than the M1 money supply, which only includes the most liquid forms of money.

It operates by providing a broader measure of the amount of money available in an economy, which can be used to support economic activity. The M2 money supply is exclusively useful to monetary authorities, business owners and individuals.

Basically, individuals and businesses can monitor the M2 money supply as a way of understanding broader economic trends and making informed financial decisions. For example, changes in the M2 money supply can affect the availability of credit and the cost of borrowing, which can impact business investment and consumer spending.

Hence, understanding how the M2 money supply operates can help individuals and businesses make strategic financial decisions that support their financial goals.

The components of M2 represent different levels of liquidity, which means that some forms of money are more easily used for transactions than others. The various components of M2 are typically held by different types of institutions and individuals, and they may have different interest rates and other characteristics. Below is a brief highlight of the components of the M2 money supply:

  1. M1 money supply includes the most liquid forms of money, such as physical currency, checking account deposits, and traveller’s checks.
  2. Savings deposits include savings accounts, money market accounts, and certificates of deposit (CDs). These are less liquid than M1 money but can still be converted into cash relatively quickly.
  3. Time deposits include CDs and other time deposits that are held for a fixed period of time before they can be withdrawn. These are less liquid than M1 and savings deposits.
  4. Retail money market mutual funds are mutual funds that invest in short-term, low-risk securities such as government bonds and certificates of deposit. They are less liquid than M1 and savings deposits but can still be easily converted into cash.

M2 and Inflation

As said before, M2 serves as a broader measure of the money supply in an economy compared to M1, which only accounts for money held by the public. As a result, M2 has so far proven to be a useful indicator of potential changes in inflation levels.

If the M2 money supply increases, inflation may rise, and if it is restricted by central banks, inflation may fall. However, there is typically a lag of 12 to 18 months for inflation to respond to increased monetary supply. It is important to note that inflation will only increase if the money supply grows without a corresponding increase in economic output. If economic output increases alongside the money supply, inflation may not increase at all.

Calculating M2

The M2 money supply is calculated by adding up several components, which represent different types of assets that are widely accepted as a means of payment in the economy. The specific components of M2 can vary slightly depending on the country and the organization measuring it. However, in the United States, the components of M2 are typically currency in circulation, demand deposits, savings deposits, money market deposit accounts, and time deposits.

To calculate M2, simply add up the values of these five components. The resulting total represents the amount of money in the economy that is readily available for spending and investment but excludes assets that are less liquid or not widely accepted as a means of payment. It is important to note that the specific components and calculation methods for M2 can vary across countries and over time, so it is always best to consult reliable sources for the most up-to-date information.

M2 vs M1 vs M3

M1 and M2 are the most commonly used measures of money supply, with M1 being the most narrowly defined and M2 being the broader measure that includes M1 plus additional types of deposits. M3 is less commonly used, as it includes assets that are not as widely accepted as a means of payment and may be less relevant for measuring the overall liquidity of the economy.

M1, M2, and M3 are different measures of money supply in an economy, with each measure including different types of assets. Let’s have a look at a brief overview of each measure:

  • M1 – the narrowest measure of the money supply and includes the most liquid types of money, such as physical currency and coins in circulation, and checking deposits that can be easily converted into cash.
  • M2 – a broader measure of the money supply that includes all the assets in M1, as well as other types of deposits that are less liquid but still widely accepted as a means of payment, such as savings deposits, money market deposit accounts, and small-denomination time deposits.
  • M3 – the broadest measure of the money supply and includes all the assets in M2, as well as other types of assets that are not as widely used as a means of payment, such as large-denomination time deposits, institutional money market funds, and other forms of money held by financial institutions.

Bottom Line

The M2 money supply is a broader measure of the money supply in an economy than M1, as it includes all the assets in M1 plus other types of deposits that are less liquid but still widely accepted as a means of payment. M2 is an important indicator for measuring the overall liquidity of an economy, as well as for assessing potential inflationary pressures and the impact of monetary policy. Central banks use M2 as a tool for managing the money supply and achieving their economic objectives, such as controlling inflation and promoting economic growth. Ultimately, the M2 money supply provides important insights into the health of an economy and is a critical component of macroeconomic analysis and policymaking.

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FAQ

What is the money supply?

Money supply refers to the total amount of money that is circulating in a country’s economy at a given time. It includes all forms of money, such as cash, bank deposits, and other financial assets that can be used as a means of exchange.

What is the M2 money supply?

The M2 money supply is a broader measure of the money supply in an economy than M1, as it includes all the assets in M1 plus other types of deposits that are less liquid but still widely accepted as a means of payment.

How to calculate M2?

The M2 money supply is calculated by adding up several components, which represent different types of assets that are widely accepted as a means of payment in the economy.

How do central banks influence M2?

Central banks have various tools to influence the growth of the M2 money supply, such as open market operations, reserve requirements, discount rates, and direct lending. These tools enable central banks to control the level of liquidity in the economy and achieve policy objectives, such as promoting economic growth, controlling inflation, and maintaining financial stability.

What is the M1 money supply?

The M1 money supply is the narrowest measure of the money supply and includes the most liquid types of money, such as physical currency and coins in circulation, and checking deposits that can be easily converted into cash.

What is the M3 money supply?

The M3 money supply is the broadest measure of the money supply and includes all the assets in M2, as well as other types of assets that are not as widely used as a means of payment, such as large-denomination time deposits, institutional money market funds, and other forms of money held by financial institutions.

What happens when the M2 money supply increases?

An increase in the M2 money supply poses the risk of inflation increase to the economy. Hence, if the M2 money supply increases, inflation may rise, and if it is restricted by central banks, inflation may fall.

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