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Key Takeaways

M2 (money supply) is a way to measure how much money is moving around in the economy. It includes money that people use every day, like cash and money in checking accounts.

M2 also includes money that isn’t used as often but can still be spent fairly quickly, like savings accounts and money market funds.

M2 is an important economic indicator because it helps economists and policymakers understand how much money is available for spending and investing.

What Is M2 (Money Supply)?

M2 is a way to measure the total money circulating in an economy. It includes both highly liquid money, such as cash and checking deposits (M1), as well as less liquid assets, such as savings accounts, time deposits, and money market funds.

Economists, government officials, and investors look at M2 to understand how healthy the economy is. If there’s a lot of money out there, people and businesses are more likely to spend more. If there’s less money available, spending will naturally slow down.

What Is M2 Made of?

The US Federal Reserve calculates the M2 using multiple components, including cash and money in checking and savings accounts. It also includes certificates of deposits (CDs) and other assets that can be easily converted to cash.

1. Cash and checking accounts (also called M1)

This is the most basic and liquid form of money. It includes:

Physical currency (coins and paper money).

Money in checking accounts, which can be used with a debit card or checks

Traveler’s checks (less common today but still included in M1).

Other checkable deposits (OCDs). These are highly liquid accounts that can be used to make payments by check or debit card.

2. Savings Accounts

These are bank accounts where people keep money they don’t need right away. While savings accounts usually pay interest, they can have limits on how often you can take money out.

3. Time deposits

These are also called certificates of deposit (CDs). You agree to leave your money in the bank for a certain amount of time, and in return, the bank pays you interest. These deposits are usually under $100,000.

4. Money market funds

These are a type of mutual fund that invests in safe, short-term investments. They usually offer higher interest than savings accounts but have some restrictions on how you can use your money.

How Does M2 Work?

M2 reflects the total money available in an economy, including funds that can be easily converted into cash. If M2 is growing, it means more money is available. People might be saving more, borrowing more, or receiving more income. This often leads to more shopping, investing, and business activity.

If M2 is shrinking or not growing much, it may suggest that people are spending less or saving more. With less money in circulation, the economy tends to slow down. Businesses may earn less, and unemployment may rise.

What Changes M2?

1. Central bank decisions

Through monetary policies, central banks manage interest rates and set rules for how much money banks must keep in reserve. When the Fed lowers interest rates, borrowing becomes cheaper, meaning people and businesses are more likely to take loans, adding money to M2.

2. Government spending

If the government gives out stimulus checks or boosts public spending, that can increase the money supply. The opposite is true if the government cuts spending or raises taxes.

3. Bank lending

When banks give out more loans, money is created and added to the economy. This increases M2. When banks lend less, M2 may grow more slowly or even shrink.

4. Consumer and business behavior

If people and companies decide to save more and spend less, the money sits in savings accounts instead of circulating. That can slow down M2 growth.

M2 and Inflation

When more money is available, people and businesses tend to spend more. If this spending grows faster than the economy’s ability to produce goods and services, prices may rise, leading to inflation.

On the other hand, if M2 stops growing or starts shrinking, inflation may slow down. But if it shrinks too much, it could also mean the economy is slowing or even heading into a recession.

That’s why central banks and policymakers watch M2 closely. If they think M2 is growing too fast, they might raise interest rates to cool off the economy. If it’s shrinking too much, they might lower rates to encourage spending.

How M2 Affects Financial Markets

M2 has a significant impact on financial markets, including cryptocurrencies, stocks, bonds, and interest rates.

Cryptocurrencies

When M2 is rising and interest rates are low, some investors may move money into cryptocurrencies, looking for higher returns. During periods of easy money, crypto prices often go up. But, if M2 contracts and borrowing becomes more expensive, people may pull out of riskier assets like crypto, causing prices to drop.

Stocks

The effects of M2 on stocks are similar to those of crypto markets. When M2 is growing, people have more money to trade or invest in stocks. This tends to push prices up. If M2 slows down or shrinks, markets are more likely to fall.

Bond market

Bonds are often seen as safer investments. When M2 grows, and interest rates are low, bonds usually become more attractive as investors look for more reliable returns. If M2 shrinks and interest rates rise, we can expect bond prices to fall.

Interest rates

Interest rates often move in the opposite direction of M2. If M2 is growing too fast, central banks might raise interest rates to slow things down and fight inflation. If M2 is shrinking too much, they may lower rates to support spending and borrowing.

A Real-Life Example: COVID-19 and M2

During the COVID-19 pandemic, the US government sent out stimulus checks, increased unemployment benefits, and the Federal Reserve lowered interest rates. All of this led to a huge increase in M2.

By early 2021, M2 was growing by nearly 27% compared to the year before. This was a record-high increase. But in 2022, as the Fed raised interest rates to fight inflation, M2 growth slowed down, turning negative in late 2022. That contraction signaled a cooling economy and a potential decline in inflation.

Why M2 Matters

M2 is a simple but powerful tool for understanding the economy. If it’s growing fast, it could mean inflation is coming. If it’s shrinking, it could be a warning of slower growth or even a recession.

People who make decisions about interest rates, taxes, and spending use M2 to guide their choices. Investors also watch M2 to get a sense of where markets might be headed.

Closing Thoughts

M2 is more than just a number. It shows how much money is in the system and ready to be used. It includes everyday money like cash and checking accounts, plus near-money like savings and CDs.

Watching M2 helps us understand where the economy might be going. Fast growth can bring more jobs and spending but also higher prices. Slower growth might help control inflation but can also slow down businesses.

Further Reading

Interest Rates Explained 

What Is Monetary Policy?

What Are Bonds and How Do They Work?

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