The money supply of an economy plays a vital role in determining how traditional supply and demand models affect the market, irrespective of which asset you’re dealing with. Acting as a key market indicator of several aspects, the money supply of an economy can tell you many things with respect to price fluctuations and liquidity, giving any informed investor an advantage when it comes to making investment decisions. Have you ever wondered how much of the money in an economy is actual physical cash, numbers on a computer, or has been invested into different assets like commodities, bonds, and stocks? Well then, you’ve come to the right place. Let’s go over how money is defined and classified within an economy and why that’s so important for investors.
This is not financial investment advice.
This article will touch upon key aspects of how money is classified and defined within an economy and how that can serve as an indicator.
In this article
- What’s Money Supply?
- Classification of Money
- How Money Supply Affects The Economy
- Money Supply As An indicator
What’s Money Supply?
So let’s get straight into it, the money supply is the the entire stock of currency and other liquid instruments circulating in a country’s economy as of a particular time. The money supply of an economy can include cash, coins, and balances held in checking and savings accounts. Economists look at the money supply and use their analysis to develop policies revolving around it by controlling interest rates and increasing or decreasing the amount of money flowing in the economy.
The money supply reflects the different types of liquidity each type of money has in the economy, which can actually be classified even further. Data and statistics regarding the actual money supply of an economy is typically recorded and published by the it’s central government or bank. As such, investors can use this data to perform sector analysis of a specific market in an economy to assess its financial condition with respect to asset performance.
The money supply represents the entire stock of currency circulating within a nation’s economy. This can be further classified (as detailed in the next section) and used by investors to assess market performance.
Classification of Money
As it turns out, the entire money supply of an economy can be broken down and classified into different categories depending on how liquid it is. The liquidity of money refers to the extent to which a market, such as a country’s stock market or a city’s real estate market, allows assets to be bought and sold at stable prices.The different categories of money are separated by which “M” they correspond to: M0, M1, M2 and M3.
These differing categories of liquidity vary country to country, as some economies may use a completely different set of classifications for their money supply. Generally speaking, M0 and M1 are referred to as “narrow money” which includes coins, notes, and any other instrument in circulation that is easily convertible to cash. Moreover, M2 includes all of M1 and any short-term time deposits in banks and certain money market funds. M3 includes M2 in addition to long-term deposits. However, it should be noted that M3 is no longer included in the reporting by the Federal Reserve.
Specifically for the United States, The Federal Reserve measures and publishes the total amount of M1 and M2 money supplies on a weekly and monthly basis. They can be found online and are also published in newspapers, giving any investor who chooses to utilize this information an advantage through sector analysis. Economists already use this information to make models and policies which help people on a broader scale, but investors can also use this information to make more informed decisions when it comes to market performance.
Money is classified into different categories depending on its liquidity and size. Specifically for the United States, money is broken down into M0 & M1 (coins and direct notes), M2 (M1 and short-term bank deposits), and M3 (M2 and long-term deposits).
How Money Supply Affects The Economy
As we already stated, data and statistics on the money supply of an economy can be utilized to make better decisions regarding market performance. Economists use the money supply to gain a better understanding of how the economy is performing, also giving them a tool to adjust certain policies which can impact the economy as a whole. Fundamental supply and demand models are used by experts to forecast price movements which are caused by changes in interest rates.
According to conventional macroeconomic theory, an increase in the supply of money usually impacts the market by lowering the interest rates throughout the economy, leading to more consumption and borrowing. In the short run, this can also correlate to an increase in total output and spending which ultimately increases the Gross Domestic Product, or GDP.
The long-term impacts of a change in the money supply are a bit more difficulty to analyze, as a number of outside factors also play a role in determining its effect. There is, however, a strong historical tendency for asset prices such as housing and stocks, to artificially rise after too much liquidity enters the economy. Resultantly, the misallocation of capital leads to speculative investments, often leading to bubbles and recession.
Increasing or decreasing the money supply can have a number or impacts on an economy as a whole. Economists use the money supply as a tool to enact policies which keep the economy as stable as possible.
Money Supply As An Indicator
So then, why does all of this matter for someone who’s interested in investing? Well, the data and statistics revolving around an economy’s money supply can give people who know how to use it an advantage when it comes to making financial decisions. Each money supply report that is published weekly details how many funds are currently floating in the market and thus ready to be used anytime by consumers, investors, or even by the government.
Within the United States, for example, the Federal Reserve publishes this report and has been consolidating data on M1 and M2 money supply since the 1950s. Today, the Federal Reserve no longer develops expectations and objectives for money supply, but continues to gather data in order to determine any possibility for inflation and determine consumer behavior — particularly in spending.
The Federal Reserve can also take part in the way that money is supplied in the market by performing open market operations. They can sell and buy treasuries, develop reserve requirements, and change the money supply to better situate the economy for long-term sustainability and growth. Since it’s released on a weekly basis, the money supply report can serve as a timely indicator. Since most figures will remain relatively constant, there will also be fewer changes so if you know how to read the report, you can use it to make wise decisions in investing and spending your cash.
Moreover, with data dating back the 1950s, historical averages are readily available to make comparisons and establish a relationship among inflation, GDP, and money supply. The report may not have any bearing on predicting spending growth, it can still be handy in identifying if there’s going to be inflation.
The money supply — which is detailed in the weekly money supply report for the United States — can serve as a timely indicator for investors and consumers looking to make more informed decisions. Investors can use this information to better assess the market before buying or selling their assets.
Overall, the classification and definition of “money” varies from economy to economy, but understanding how it functions is universally important. The relationship and correlation between money supply and price movements has been evident for some time now, so investors seeking to gain a better understanding of how the economy works as a whole should take time to familiarize themselves with the money supply and how it impacts a market. Valuation methods including sector analysis can be executed using the money supply data available, potentially serving as an extra insight into how that market is performing. Moving forward, continue to read reports detailing your economy’s money supply and continue to make connections between changes in the money supply and market performance. As always, happy investing!
Have you noticed any other relationships between money supply and economic performance?
Let us know in the comments!