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The money supply is the total amount of money in an economy at a particular time. It is determined by the amount of currency in circulation and the number of bank deposits. The money supply can be increased by increasing the amount of currency in circulation or by increasing the number of bank deposits.
Money supply formula
The money supply is the total amount of money in an economy at a given time. It is calculated by adding together the amount of currency in circulation and the amount of money in bank deposits. The money supply formula is:
M1 = Currency in circulation + Money in bank deposits
M2 = M1 + Money market mutual funds + Savings deposits + Small-denomination time deposits
M3 = M2 + Institutional money market mutual funds + Repurchase agreements + Eurodollars
M4 = M3 + Certificates of deposit + Repurchase agreements
The money supply can be used to calculate the velocity of money, which is the average number of times a unit of money is used to purchase goods and services in a given time period.
Types of money supply
There are three types of money supply- M0, M1, and M2.
M0- It is the total amount of currency in circulation and consists of coins and paper notes.
M1- It is the sum of currency in circulation and demand deposits, i.e. checking accounts.
M2- It is the sum of M1 and savings deposits and money market mutual funds.
M0, M1, and M2 are also known as narrow, broad, and ultimate money supply respectively.
Why is money supply important?
The amount of money in an economy affects the level of prices, the level of economic activity, and the amount of money available to borrowers.
The government can increase the money supply by printing more money, or by borrowing money and lending it to banks, which can then lend it to people and businesses.
When the government increases the money supply, it can cause prices to rise and lead to inflation.
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Use the term in context
Money is not just cash in a wallet. In economics, different measures count different kinds of money depending on how quickly they can be used for payment. Narrow measures focus on the most liquid forms, while broader measures can include deposits and other near-money components defined by the country’s central bank.
For India, students should use the Reserve Bank of India’s definitions when answering questions about monetary aggregates, because labels and component groupings are policy terms rather than casual everyday language. When comparing countries, do not assume that an M1 or broad-money label has exactly the same components everywhere.
Simple way to study it
- Start with function: medium of exchange, unit of account and store of value.
- Then study liquidity: how quickly an asset can be used to make payment.
- Then study aggregates: which deposits and instruments the central bank includes in each measure.
- Finally connect it to policy: money supply data are used with inflation, credit, interest rates and economic activity, not in isolation.
Check the current version before acting
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