What is the Money Supply?
The M2 measure of the money supply includes currency, demand deposits, other checkable deposits, traveler's checks, savings deposits, small denomination time deposits, and balances in money market mutual funds. Thus M2 consists of both money and assets that can be exchanged for money at little cost. If growth in the money supply does not keep pace with economic growth, the economy has a tendency to contract. In contrast, if growth in the money supply outpaces economic growth, more dollars chase fewer goods, which ultimately is inflationary. The Federal Open Market Committee (FOMC) meets monthly to make decisions on whether to expand or contract the supply of money in the economy. The Federal Reserve (Fed) has three tools at its disposal to regulate M2. The Fed can quickly change the money supply by purchasing or selling U.S. government securities. For example, purchasing government securities expands the money supply because securities purchased from the public are paid for in dollars held by the Fed which are not a part of the money supply. Thus when the Fed purchases securities it injects money into the economy. The Fed also controls the money supply through changes in the discount rate (the rate the Fed charges on loans to banks), and by increasing or decreasing reserve requirements for commercial banks. Banks are required to hold a percentage of their deposits as reserves to serve the liquidity needs of depositors. When the Fed reduces required reserves, the money supply expands because banks can then loan a larger percentage of deposits to individuals and businesses.
By increasing the supply of loanable funds, an increase in the money supply tends to reduce interest rates, unless the increase creates strong inflation expectations. Lower interest rates in turn spur additional borrowing and spending by businesses and households, which ultimately increases real output. Unfortunately, if the money supply increases too quickly, inflation tends to heat up, which is bad for investors and consumers alike because it erodes purchasing power.
The M2 measure of the money supply is an important and highly weighted element of the Index of Leading Economic Indicators. The reason is because of the strong economic relationship between current monetary policy and future economic growth.
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