Let’s explore the broadest measure of money in an economy, which includes physical currency, checking accounts, savings accounts, and other liquid assets – the M3 money supply.
To determine an economy’s money supply, economists use such money aggregates as M1, M2, and M3. M1 money supply includes money in circulation plus checkable deposits in banks. M2 money supply includes M1 plus savings deposits (less than $100,000) and money market mutual funds. Meanwhile, M3 is known as ‘broad money’ and includes all the components of the M2 money supply, such as currency in circulation, checking deposits, savings deposits, and small-denomination time deposits, as well as larger time deposits, institutional money market funds, and other liquid assets. Here, we will focus on the M3 money supply and its impact on the economy.
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.
M3 Money Supply Explained
M3 is a comprehensive measure of the money supply in an economy, which encompasses all components of the M2 money supply along with larger time deposits, institutional money market funds, short-term repurchase agreements (repo), and other substantial liquid assets.
The M3 money supply is a measure of the amount of money in circulation in an economy which works by tracking the different types of money available in the economy and adding them together to get a total measure of the money supply.
Central banks, such as the Federal Reserve in the United States or the European Central Bank in Europe, track the M3 money supply by gathering data from financial institutions and other sources. They use this information to monitor the overall health of the economy and make decisions about monetary policy.
Meanwhile, changes in the M3 money supply can have a significant impact on the economy. For example, an increase in the money supply can lead to lower interest rates, which can encourage borrowing and spending, and stimulate economic growth. Conversely, a decrease in the money supply can lead to higher interest rates, which can reduce borrowing and spending, and slow down economic growth.
As such, understanding the M3 money supply is crucial for policymakers, investors, and anyone interested in the health and stability of the economy.
M3 and Inflation
The relationship between M3 and inflation is complex and not always straightforward. In general, an increase in the money supply can lead to inflation, as more money chases the same amount of goods and services, driving up their prices. This relationship is based on the Quantity Theory of Money, which states that the price level in an economy is proportional to the amount of money in circulation.
Other factors such as productivity growth, changes in the velocity of money, and shifts in supply and demand for goods and services can also affect inflation. For example, if productivity grows faster than the money supply, the price level could remain stable or even decrease despite an increase in the money supply.
Moreover, M3 includes assets that are less liquid and more difficult to use as a means of payment than other components of the money supply. These assets may have a limited impact on inflation since they may not be used as frequently in transactions as more liquid assets.
Central banks typically use monetary policy tools such as interest rate changes and open market operations to influence the money supply and control inflation. They aim to maintain price stability by keeping inflation within a target range that is considered healthy for the economy. However, the effectiveness of these tools and the ability of central banks to control inflation depend on various economic and political factors, and their success is not always guaranteed.
Calculating M3
The M3 measurement comprises assets categorized as “near money” that have relatively lower liquidity compared to other constituents of the money supply. These assets have greater relevance to the financial affairs of large financial institutions and corporations as opposed to small businesses and individuals. Hence, the M3 money supply is calculated by adding together all of the following components:
- Currency in circulation. This includes all paper currency and coins that are in the hands of the public.
- Checking deposits. These are funds held in checking accounts that can be accessed by writing a check, using a debit card, or making an electronic transfer.
- Savings deposits. These are funds held in savings accounts that earn interest but may have restrictions on how often they can be withdrawn.
- Small-denomination time deposits. These are deposits that are held in banks for a fixed period of time, usually less than $100,000.
- Large-denomination time deposits. These are deposits that are held in banks for a fixed period of time, usually more than $100,000.
- Institutional money market funds. These are funds that invest in short-term, low-risk securities and are designed to be highly liquid.
- Other liquid assets. This includes any other assets that can be quickly and easily converted into cash, such as Treasury bills or commercial paper.
M2 vs M1 vs M3
M1, M2, and M3 are different measures of the money supply, each with varying degrees of liquidity and components. Meanwhile, M3 encompasses all other categories of money, along with additional assets that are less liquid and not included in the other measures of the money supply.
The differences between these measures reflect varying degrees of liquidity and availability for use in transactions. M1 represents the most immediately available money for transactions. It is the narrowest measure of the money supply and includes the most liquid assets, such as physical currency in circulation, checking account deposits, and traveller’s checks. It represents the money that is readily available for use in transactions. M2 is a broader measure of the money supply than M1 and includes all of the components of M1, as well as savings account deposits, money market mutual funds, and other time deposits. These assets are less liquid than those included in M1 but are still considered relatively easy to access.
As said before, M3 is the broadest measure of the money supply and includes all of the components of M2, as well as larger and less liquid assets, such as institutional money market funds, large-time deposits, and repurchase agreements. These assets are referred to as “near money” and are less frequently used in transactions by individuals and small businesses than by larger financial institutions and corporations.
Bottom Line
It is important to understand that the M3 money supply is a broad measure of the money supply that includes all of the components of M2 and additional, less liquid assets such as institutional money market funds and large-time deposits. While an increase in the money supply can lead to inflation, the relationship between M3 and inflation is complex and not always straightforward, as other factors such as productivity growth and shifts in supply and demand can also affect inflation.
Thus, the central banks use measures of the money supply to monitor and manage the economy, particularly in relation to inflation and overall economic growth. The choice of which measure to use depends on the specific goals of the central bank and the characteristics of the economy being measured.