Money supply

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Printing currency doesn’t necessarily increase the money supply.

© borisblik/stock.adobe.com; Photo illustration Encyclopædia Britannica, Inc.

Money supply is the total amount of spendable funds available in a country’s economy. This typically refers to cash, coins, and bank deposits—monetary assets that are easily accessible and convertible to spendable funds. Economists measure the money supply using several categories, or monetary aggregates, commonly designated M0, M1, M2, M3, and M4, depending on the country. Each successive measure generally includes a broader range of monetary assets, from cash in circulation to savings deposits and other relatively liquid financial instruments. 

Some economists consider time and savings deposits (e.g., certificates of deposit, or CDs) to be part of the money supply, even though these assets are less accessible than funds in checking accounts. Broader measures also include deposits at credit unions and other financial institutions that offer services similar to commercial banks.

The money supply measures the total stock of money existing in an economy, whether it’s sitting in savings or moving through the economy (i.e., being spent). A related measure, velocity of money, tracks how frequently money changes hands through financial transactions. Together, these measures help economists understand the relationship between money, economic activity, and inflation.

In the United States, the Federal Reserve tracks two primary monetary aggregates, M1 and M2. A narrower measure, M0, generally refers to the monetary base, which includes currency in circulation and bank reserves held at the Federal Reserve.

The main difference between the two is liquidity, or how readily an asset can be used for spending. M1 consists of money that is immediately accessible, while M2 includes additional assets that generally require another step before they can be spent.

Almost every country with a central bank has its own way of measuring money supply. However, the methodologies or categories that are used to measure money supply may differ. For example, the Bank of England (BoE) once had five historical tiers—M0, M1, M2, M3, and M4—but now concentrates on two:

The European Central Bank (ECB), which oversees monetary policy for the 21 countries in the eurozone, uses three monetary aggregates to measure the money supply:

Although central banks use different methods to measure and manage the money supply, they share a common goal: maintaining monetary and economic stability. And because monetary assets have different degrees of liquidity—meaning some are more readily available for spending than others—tracking multiple aggregates helps central banks distinguish between money available for immediate spending and money held in savings or other less liquid accounts.

Central banks, commercial banks, and governments all play a role in expanding or contracting the money supply, although they do so in different ways.

Central banks also oversee the issuance of physical currency. In the U.S., the Bureau of Engraving and Printing (part of the U.S. Department of the Treasury) produces paper money, while the U.S. Mint produces coins. The Federal Reserve orders currency as needed and distributes it to commercial banks, which put it into circulation through withdrawals and other transactions.

But printing currency doesn’t necessarily increase the money supply. When someone withdraws $100 from a checking account, they’re exchanging $100 in deposits for $100 in cash. The form of money changes, but the total doesn’t.

Changes in the money supply can help you understand broader economic conditions and assess potential opportunities and risks. Two important connections are the relationship between money supply and inflation, and the role of interest rates in monetary policy.

The core premise of the quantity theory of money is that the total amount of money in the economy influences price levels and the overall inflation rate. So if the money supply grows, particularly M2, upward pressure on prices can follow. If the money supply shrinks, that pressure will typically ease.

There’s a classic formulation for this relationship called the equation of exchange (MV = PQ). It states that the money supply (M) times its measured circulation or use in purchases (its “velocity” or V) equals price levels (P) times the quantity of output (Q). Milton Friedman, a Nobel Prize–winning economist and leading proponent of the quantity theory, put it bluntly: “Inflation is always and everywhere a monetary phenomenon.”

Not every economist agrees. Parts of the equation aren’t always steady, particularly velocity. For example, if the money supply increases but the funds are saved rather than spent, inflationary pressure can be reduced. Output (Q) is also variable: If the economy has unused productive capacity, an increase in the money supply can raise output without a corresponding increase in prices.

In other words, the equation is an identity, not proof of cause and effect.

Interest rates are one of the main levers used by central banks to steer monetary policy. Their actions provide clues about the direction of monetary policy and its potential economic consequences.

When inflation is high, central banks may raise interest rates to cool growth. Raising borrowing costs slows the pace of commercial and corporate lending, which in turn slows the pace of money creation. If higher interest rates mean that borrowers repay existing loans at a faster rate than banks issue new ones, the money supply can actually contract. Higher borrowing costs also prompt people and businesses to save rather than spend, potentially slowing the velocity of money and easing inflationary pressure.

The reverse generally happens when a central bank cuts interest rates. Cheaper borrowing costs tend to increase the rate of borrowing and spending. The issuance of new loans adds to the money supply, and increased spending can accelerate velocity. Consequently, the increase in economic activity spurs economic growth, and can contribute to inflation.

As an investor, watching the money supply along with central bank interest rate decisions can help you follow developments in the broader economy. Although the size and timing of these effects may vary, these indicators provide useful context for assessing economic conditions and potential risks.