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Money supply is the total amount of money circulating in the economy at a particular time, often measured on a country-by-country basis.
The reason that money supply is important is that it can drive inflation or deflation, affect the price of investments, influence exchange rates, and in some cases, impact economic and business cycles.
For this reason, money supply is tracked by the government or central bank of each country to keep track of a nation’s economic health and stability.
Types of Money Supply
While there’s lots of money floating out in the world, in reality, it can be separated into three simple categories.
The three types of money supply are known as M1, M2, and M3 money:
M1 Money
M1 money is active money. It includes all physical currency, including paper money and coinage, checking accounts, travelers’ checks, and similar accounts.
This is money that is immediately available to make purchases payments.
M2 Money
M2 money includes everything in M1, plus time-related deposits and non-institutional money market funds.
It is any money easily liquidated into cash.
M3 Money
M3 money is everything in M1 and M2, plus large deposits, institutional money market funds, significant liquid assets, and short-term repurchase agreements.
This is money that is less liquid than other components of the money supply.
The Fractional Reserve System
At a basic level, measurements of money supply exist to track the process of money creation.
Commercial (for-profit) banks play a major role in the process of money creation, in large part, because of the fractional reserve banking system used in the U.S. and worldwide.
Based on the fractional reserve system, when you put $100 in the bank, the bank is allowed to lend out $90 of it, keeping only $10 as mandated bank reserves. If the people/businesses who receive that $90 place it into a bank, then $81 can be lent out (90%). And so on. It is estimated that this system allows one dollar to be lent out up to 100 different times.
This means that a single dollar can multiply itself. Pretty fascinating, right? And, hopefully a little concerning too?
If you want to know financial speak, this is called the “multiplier effect.” It means money is created whenever a bank gives out a loan.
In short, the money supply needs to be tracked, because our financial systems allow it to multiply itself and shape-shift into new forms.
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