Money Supply definition

Money supply is the total amount of currency in circulation in a country. The different types of Money are classified as M0, MB, M1, M2 and M3. The most important economic indicator used to monitor a country’s money supply is Money Supply M2.

Money supply is controlled by the central bank’s monetary policy. Monetary policy is a set of actions conducted by the nation’s central bank to expand or contract economic activity by expanding or contracting the money supply. These actions affect the central bank’s balance sheet.

The central prints new money and expands the money supply by increasing the supply of two money types: currency in circulation and reserves.

Currency in circulation is money in physical form notes and coins. Reserves consist of deposits of commercial banks held at the central bank and any currency that is physically held by banks.

The central bank uses three tools to expand or contract money supply: 1. Open market operations, 2. Discount loans and 3. Reserve requirements.

Open market operations: The central bank prints new money and uses it to purchase government securities like bonds in the open market. The previous holder of the government securities purchased by the central bank ends up with the newly issued money held as reserves in the banking system. This causes an expansion in the monetary base and the money supply.

Discount lending: The central bank makes discount loans to commercial banks. A discount loan leads to an expansion of banking reserves which can be used for making loans and an expansion of the money supply.

Reserve Requirements: The central bank sets a reserve requirement which is a certain fraction of customers’ deposits commercial banks must hold in reserve with the central bank. When the central bank reduces reserve requirements, it causes an increase in banking reserves and an expansion of the money supply.

Money Supply Indicators

The different indicators of money supply are analysed below:

Money Supply M0: M0 is the sum of notes and coins in circulation.

Monetary base (MB): MB is the monetary base or total currency.

Money Supply M1: M1 is the sum of notes and coins in circulation, demand deposits and other checkable deposits (OCD). Bank reserves are not included in M1

Money Supply M2: M2 is the sum of M1 components plus saving deposits, time deposits of less than $100,000 and money market deposit accounts. Money supply M2 is the most important economic indicator used to monitor money supply.

Money supply M3: M3 is the sum of M2 components and long-term deposits.

Learn more about a nation’s monetary policy tools.