Money Supply

Money Supply, amount of money freely circulating in an economy. Money supply is made up of currency (paper bills and coins) and bank deposits. The United States divides money into four categories known as measures: M1, M2, M3, and L.

This breakdown measures the money supply by degree of liquidity. Liquidity refers to how easy it is to convert money into cash—the most liquid form of money. Checking accounts represent the next most liquid form because money in a checking account can be easily withdrawn by writing a check. Savings accounts are slightly more difficult to access than checking accounts and therefore are less liquid. Certificates of deposit are less liquid still because often funds cannot be withdrawn before a specified date without a penalty.

Each measure of money includes a portion of the money supply that is more liquid than the next measure—that is, M1 is more liquid than M2. The measures are cumulative; each measure includes the forms of money (cash, savings accounts, U.S. treasury bonds, etc.) counted in the previous measure, plus additional, less liquid forms. For example, M2 includes M1 plus certain additions.

Definitions of different money supply measures include a number of technical items, but, in a general sense, M1 is the most liquid and includes cash, travelers checks, and demand deposits—checking accounts from which money can be withdrawn on demand. In 1994 M1 in the United States averaged over $1.1 trillion on a daily basis. M2 is less liquid. It consists of M1 plus savings deposits of $100,000 or less. M3 consists of M2 plus savings deposits of more than $100,000. L consists of M3 plus government securities, such as savings bonds and treasury notes.

In the United States, money supply is manipulated by the Federal Reserve Bank with one of three methods: buying and selling government securities; raising or lowering banks' required reserve ratio (percentage of their total deposits that banks must maintain at Federal Reserve banks); and raising or lowering the discount rate (interest rate banks pay to borrow money from the Federal Reserve).

Money supply is an important aspect of government monetary policy. Governments use monetary policy, along with fiscal policy (which is concerned with taxation and spending), to maintain economic growth, high employment, and low inflation. In the United States, monetary policy is determined by the Federal Reserve's Board of Governors.

Economists disagree on the ultimate effects of changes in the money supply. Two important schools of economic thought are Keynesianism and monetarism. Keynesians believe that an increased money supply can lead to increased employment and output. On the other hand, monetarists argue that an increased money supply ultimately only affects prices, leading to inflation, and that output is not increased.