Money Supply

M1
Cash in circulation plus demand deposits at commercial banks. There are variations between the precise definitions used by national financial authorities.

M2
Includes demand deposits time deposits and money market mutual funds excluding large CDs.

M3
In the UK it is M1 plus public and private sector time deposits and sight deposits held by the public sector.

M1 is the base measurement of the money supply and includes currency, coins, demand deposits, traveler’s checks from non-bank issuers, and other checkable deposits.

M2 is equal to M1 plus overnight repurchase agreements issued by commercial banks, overnight Eurodollars, money market mutual funds, money market deposit accounts, savings accounts, time deposits less than $100,000.

M3 is M2 plus institutionally held money market funds, term repurchase agreements, term Eurodollars, and large time deposits.

L, the fourth measure, is equal to M3 plus Treasury bills, commercial papers, bankers, acceptances, and very liquid assets such as savings bonds.

In the UK the main measures of money supply are:

M0: Sterling notes and coins in circulation outside the Bank of England including those held in tills of banks and building societies plus banks’ operational deposits with the Bank of England. Also known as narrow money.

M4: M0 plus all sterling deposits at UK monetary financial institutions held in the M4 private sector. Also known as broad money.

Money supply is important because money is used in virtually all economic transactions, it has a powerful effect on economic activity. An increase in the supply of money puts more money in the hands of consumers, making them feel wealthier, thus stimulating increased spending.

Business firms respond to increased sales by ordering more raw materials and increasing production. The spread of business activity increases the demand for labor and raises the demand for capital goods. In a buoyant economy, stock market prices rise and firms issue equity and debt. If the money supply continues to expand, prices begin to rise, especially if output growth reaches capacity limits. As the public begins to expect inflation, lenders insist on higher interest rates to offset an expected decline in purchasing power over the life of their loans.

Opposite effects occur when the supply of money falls, or when its rate of growth declines. Economic activity declines and either disinflation (reduced inflation) or deflation (falling prices) results.

Federal Reserve policy is the most important determinant of the money supply. The Federal Reserve affects the money supply by affecting its most important component, bank deposits.

The Federal Reserve requires commercial banks and other financial institutions to hold as reserves a fraction of the deposits they accept. Banks hold these reserves either as cash in their vaults or as deposits at Federal Reserve banks. In turn, the Federal Reserve controls reserves by lending money to banks and changing the “Federal Reserve discount rate” on these loans and by “open-market operations.”

The Federal Reserve uses open-market operations to either increase or decrease reserves. To increase reserves, the Federal Reserve buys U.S. Treasury securities by writing a check drawn on itself. The seller of the Treasury security deposits the check in a bank, increasing the seller’s deposit. The bank, in turn, deposits the Federal Reserve check at its district Federal Reserve bank, thus increasing its reserves. The opposite sequence occurs when the Federal Reserve sells Treasury securities: the purchaser’s deposits fall and, in turn, the bank’s reserves fall.

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