The money supply
M0, M1, M2 — several different definitions of how much money exists, each measuring something slightly different, none of them settling the argument.
Counting money requires deciding what counts. Cash in a wallet obviously does. A current account balance does. A three-month certificate of deposit is money you cannot spend today. The measures differ by how easily the thing can be spent.
The layers
- Base money (M0) — physical currency plus commercial banks' reserves at the central bank. The only money the central bank creates directly.
- M1 — currency in circulation plus deposits that can be spent immediately.
- M2 — M1 plus savings deposits and small time deposits. Money that is spendable with minor friction.
Exact definitions vary by country and are revised occasionally, so comparisons across borders and across long stretches of time need care.
The equation everyone quotes
Money supply × velocity = price level × real output. If money grows 10% and velocity and output are unchanged, prices rise 10%. That is the quantity theory of money, and it is an accounting identity rather than a theory — velocity is defined as whatever makes the equation balance.
The identity is always true and only useful if velocity is stable. It is not. Velocity fell substantially in several advanced economies over decades in which money supply grew strongly and inflation did not. Money created but not spent — sitting as reserves, or as deposits held rather than used — raises the measured supply and no prices.
Where the money goes
The destination matters as much as the quantity. Credit directed into asset purchases raises asset prices, which consumer price indices do not measure. Credit directed into consumption raises the prices those indices do measure. Two periods with identical money growth can produce a housing boom or a cost-of-living crisis depending on where the lending went — see how banks create money.
What it is still good for
- Sharp contractions. A falling money supply is historically associated with severe downturns, and the signal is clearer on the downside than the upside.
- Extremes. In hyperinflations the relationship between money growth and prices is direct and undeniable.
- Context for policy. Alongside bank lending, it shows whether policy is actually transmitting into the economy or stopping at the banking system.
The honest position
Most central banks stopped targeting money supply growth in the 1980s and 1990s, having found the relationship with inflation too unstable to manage policy against. That was a practical judgement rather than an ideological one. Money supply remains worth watching and is not a forecast.