Fundamental Analysis -Topic 12 Money Supply and Stock Prices

Money Supply Definition

The definition of money supply can be given in many ways. Money supply can be defined as the amount of money available within a particular economy to purchase goods or services.

According to macroeconomic theory, money supply can be defined as the amount of money and currency available with common people within a particular economy for buying goods, securities, and other services. Here the cost of money is the interest rate. In this theory, money supply is also referred as money stock or monetary aggregates.

The relationship between the rate of interest and money is opposite or reverse. For example, if the money supply goes up, the interest rates go down. At the time when the amount of money in demand is equaled to the amount of money in supply by the rate of interest, then the situation of the economy is known as the money market equilibrium.

In the United States, money supply is categorized into four types such as M0 Money Supply, M1 Money Supply, M2 Money Supply, and M3 Money Supply.

The categories are set in an ascending order (M0 to M1 to M2 to M3) and they increase in size accordingly.

The M0 money supply is defined as the narrowest form of money supply.

The Federal Reserve of the United States defines the different categories of money supply in the following manner:
M0 Money Supply Definition:
It is defined as the total amount of physical currencies along with central bank accounts, which can be converted into physical currency.


M1 Money Supply Definition:
It is defined as M0 minus the components of M0 which are held as vault cash or reserves plus the amount deposited in checking or current accounts also termed as demand accounts.


M2 Money Supply Definition:
It is defined as M1+ the majority of savings accounts, time deposits with small denominations (including CDs less than $100,000), and money market accounts.


M3 Money Supply Definition:
It is defined as M2+ every other types of certificates of deposit (CDs), repurchase agreements, and eurodollar deposits.

M1 Money Supply

M1 money supply refers to the total money supply in the economy. It includes only those demand deposits that are checkable. It includes all currency in circulation as well as demand deposits. Currency in circulation includes all minted coins and printed-paper. MO is the elementary liquidity level of money. M1 is MO and the total of non-paper or coin deposit balances without any withdrawal restrictions.

M1 and MO money supplies have a money multiplier relationship. It is the ratio of cash and coins held by people with them and in banks to the total balance in their financial accounts. In the USA, M1 money supply is those portions of MO that are held as reserves or vault cash and the amount held in demand accounts. According to December, 2006 records, the total amount of M1 in supply was about $1.37 trillion. The demand deposits that form a part of M1 money supply are those deposits where the depositors have the right to withdraw it any time. The people with demand deposit accounts can make or receive payments by cash, check and money order, direct debit, giro, standing order, SWIFT or ATM card.

There are three money supply measures. M1 is one of them while M2 and M3 are the other two. These measures show different degrees of liquidity or spendability. M1 is the narrowest measure among the three and it includes only the most liquid forms of money. Simply speaking, it includes currency in the hands of individuals, travelers checks, demand deposits and other deposits against which a check can be issued, tenders held outside banks, checking accounts minus the amount of money in the federal reserves float, Negotiable Order of Withdrawal (NOW) accounts, Super NOW accounts, Automatic Transfer Services (ATS) accounts and credit union share drafts.

For quite a long time, there was a general opinion that there is a perfect relation between M1 money supply and inflation. But this notion is on the downslide now. The money supply numbers seem to have lost some of its appeal to market participants. A strong growth in money supply is not encouraged as such a situation does lead to inflationary pressures.

M2 Money Supply

Money supply measures can be categorized into three types. They are M1, M2 and M3. These measures are based on the degrees of liquidity. M2 money supply consists of the following things:
Savings deposits, which include money, market deposit accounts.


Time deposits of small denominations, that is, time deposits that are of amounts less than $ 100,000. From this, individual retirement account (IRA) and Keogh balances at depository institutions are deducted.


Balances in retail money market mutual funds from which IRA and Keogh balances at money market mutual funds are deducted.
M2 money supplies are seasonally adjusted by adding small denomination time deposits, savings deposits and retail money funds. All these are adjusted separately and this result is summed up with seasonally adjusted M1. M2 includes savings and small time deposits, overnight repos of commercial banks and non-institutional money market accounts. According to the Federal Reserve Bank of New York, M2 was approximately $ 6.8 trillion and this amount largely consisted of savings deposits.

Broadly speaking, M2 money supply is a measure of total money supply. All the factors of M1 money supply are included in M2 and with these are added savings and other time deposits. M2 is the next level of liquidity of M1.M1 takes into its purview it includes currency in the hands of individuals, travelers checks, demand deposits and other deposits against which a check can be written, tenders held outside banks, checking accounts minus the amount of money in the federal reserves float, Negotiable Order of Withdrawal (NOW) accounts, Super NOW accounts, Automatic Transfer Services (ATS) accounts and credit union share drafts. Precisely, it includes all the currency in circulation, all paper money and minted coins.

It was in 1990s that the relationship between the performance of the economy and growth of M2 money supply became less significant. The interest rates recorded had reached an all time low in 30 years. This prompted many investors to move the funds they had in savings and time deposits that were part of M2 into bond mutual funds and stocks that are not included in the three money supply measures. If the relation between M2 and nominal income had remained as before, then the behavior of M2 would have been consistent with an economy in extreme contraction. In spite of all the limitations M2 is still considered to be the most important indicator of the financial conditions in an economy. The concept of M2 is broader than that of M1.

M3 Money Supply


Out of the three measures of money supply, M3 money supply is the broadest concept, the other two being M1 and M2. M3 is an estimate of the entire supply of money in the economy and it has experienced the all time high in the near past. It has more than doubled since 1995 and in this year itself, it has shown an approximate increase of $250 billion according to Federal Reserves data. M3 takes into its expanse, M2 and all Certificates of Deposits.

M1 includes travelers checks, currency in the hands of individuals, demand deposits and other deposits against which a check can be written, checking accounts minus the amount of money in the federal reserves float, tenders held outside banks, automatic transfer services (ATS) accounts, negotiable order of withdrawal (NOW) accounts, Super NOW accounts and credit union share drafts. Precisely, it includes all the currency in circulation, all paper money and minted coins. Along with these, M2 includes savings and other time deposits. All these are carried over into the next level of liquidity, M3.

The annual growth in Eurozone M3 money supply rose unexpectedly in the recent past. It rose to 10.9%. This credit growth may cause inflation in the future. But till date this has not been the case, though M3 has risen faster than the European Central Bank's 4.5% non-inflationary reference value.

The Federal Reserve System has announced that they would not calculate M3 monetary aggregates any more. They want to "deemphasize" the role of M3 because the M1 and M2 money supply measures have received greater importance over the years. The individual components of M3 will however be published. However, this step on the part of the Federal Reserve has not been welcomed universally, because, in the last eight years, there has been a huge increase in the money supply. Figures of M3 help a lot in tracking movements in and out of M1 and M2 over time. After all, M3 includes M2 and institutional money market mutual funds, large denomination time deposits, balances in institutional money funds and repurchase liabilities issued by depository institutions.

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