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Duration: 6:20

Level: Beginner

The Money Supply lesson discusses how M2 is calculated, where to find it, how it’s influenced and how it influences financial markets and the economy. It specifically covers some of the most popular tools used by global central banks and governments to influence the supply of money. In addition, the course covers the money supply rise in the United States and the subsequent inflationary episode in 2021.

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Study Notes:

The Money Supply also known as M2.

The Money Supply tells us how many U.S. dollars are available in the economy. The supply of Money is calculated by the American Central Bank, the Federal Reserve or simply known as the FED. It generally includes the cash in circulation, cash in bank accounts, cash in banks labeled reserves, and retail money market funds. The FED adds up all of these components to calculate the total money supply.

The FED also regulates banks, has access to bank information and are able to publish data on the banking system. These data are released on the fourth Tuesday of every month at generally 1:00 pm. It’s published within the Money Stock H.6 Release, to inform the public of the amount of liquidity or cash in the financial system and with detailed information for each component; historical data is also available.

The Money Supply is influenced by Congress and by the FED which like many other central banks, is an independent government agency but also one that is ultimately accountable to the public and Congress.

If the Central Bank feels that financial conditions should be accommodative because the economy needs help, the central bank may purchase bonds from banks in exchange for cash, lowers interest rates and reduces the amount of reserves that need to be held by banks to make money more available.

If the Central Bank thinks financial conditions should be restrictive because the economy is running too hot, the central banks may sell bonds to banks in exchange for cash, increases interest rates and increases the amount of reserves that need to be held by banks in order to make money less available. Accommodative financial conditions or “loosening” leads to a boost in the money supply while restrictive financial conditions or “tightening” leads to a stable money supply.

From a congressional perspective, increases in borrowing and spending will also boost the money supply while decreases in borrowing and spending will lead to a stable money supply.

A significant increase in the money supply will almost always lead to significant inflation unless productivity gains offset the money supply increase, a rare event. Also, if the money supply rises, interest rates globally will drift lower, the global money supply will increase, and global prices will increase as a result. Because the U.S. issues the world’s reserve currency, meaning that the U.S. dollar is the most stable and liquid form of exchange versus other currencies, the actions of the American Central Bank will likely be followed by the other larger Central Banks around the world like the European Central Bank, the Bank of England, Bank of Japan, the Bank of Canada and others.

If we wanted to forecast the direction and quantity of the money supply, we would pay close attention to the meetings and actions by Central banks and governments. Paying attention to their tone and trying to identify if they’re dovish or hawkish is important. A dovish perspective means they are leaning accommodative while a hawkish one means they are leaning restrictive. Also, analyzing the appetite for more spending and borrowing in Congress is important. Inflation acts as a political limit to excessive accommodation by central banks and governments because it’s very unpopular by the public. People hate paying more for stuff, they don’t like seeing their cash savings lose purchasing power and they also don’t like having difficulties planning for the future due to uncertain, non-stable prices.

In the 1940s Hungary and China   due to rapid money supply growth without simultaneous productivity growth. In the 80s the world witnessed the same dynamic in Nicaragua. In the 90s in Yugoslavia and Peru. Zimbabwe in the 2000s, and Venezuela in the 2010s. In the 2020s, the COVID-19 pandemic led to business shutdowns which hampered productivity in the United States and the Euro area. Both governments increased the money supply to accommodate their weak economies, since many businesses had to shut their doors and didn’t have revenues to cover expenses. Although inflationary pressures were expected to be transitory or temporary by the FED and the European Central Bank, inflation in both the United States and the Euro Area rose to the highest levels in decades.

In hindsight, if we would’ve considered the fact that a significant boost in the money supply alongside hampered productivity would mean more bills chasing fewer goods and services, we would’ve realized that inflation was going to come in a lot hotter than expected in some of the aforementioned scenarios.

For decades and decades we’ve pushed the limits of central banking on a global scale as a quick and easy way to solve complex problems. In January 2022, Interest rates are near zero and negative around most of the developed world while economic prospects are dim, labor markets are weak and inflation is hot, a perfect recipe for political and economic instability. It’s clear that economic productivity and real work solve problems and grow the economy, financial engineering and accommodative monetary and fiscal policies are not always the right answers. There’s no free lunch, be wary of global central banks and government officials when they say they can solve challenging problems by creating more money.


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