Monetary Aggregates

What are Monetary Aggregates?

Monetary aggregates are metrics that aim to quantify the amount of money in circulation within an economy available to satisfy its monetary needs.

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The money supply is used by policymakers, economists, and analysts as indicators of the state of an economy’s monetary conditions. Monetary aggregates are split into various categories, such as M0, M1, M2, and M3, which can be used in slightly different ways in different countries. These are measured as a seasonally adjusted index.

Techopedia Explains

Economists have proposed various categories of financial assets to define “money”, but there is no single definition that is widely accepted. The two most common approaches are to identify which financial assets are commonly used as a medium of exchange to pay for goods and services and as a store of value and to identify groupings of assets that correlate closely with the movements of macroeconomic variables such as national income and employment.

The US Federal Reserve used both approaches to develop the concept of monetary aggregates, starting in the 1940s.

Monetary aggregates encompass different forms of money, including cash, demand deposits, and other liquid assets that can be readily used for transactions. By tracking these aggregates, economists and policymakers gain useful information about the overall liquidity and monetary health of an economy.

The monetary base, which is commonly referred to in economic coverage, is an aggregate that includes the total amount of currency in circulation plus the commercial bank reserves stored within the central bank.

The Evolution of Monetary Aggregates

The concept of monetary aggregates has evolved over time in response to changes in global financial systems and macroeconomic conditions.

In 1944, the Fed began reporting data on currency in circulation outside banks and demand deposits at banks. This narrow measure of money supply, known as M1, was joined by other, broader definitions, including M2 and M3, as financial markets became more complex and new financial instruments were introduced.

In 1980, the Fed recalibrated the definitions, introducing M1B, which brought in additional balances held at banks. Over the years, the Fed has readjusted and refined the definitions of the various categories.

For several decades, monetary aggregates were considered key to establishing central banking policies. However, financial deregulation since the 1980s has reduced the connection between fluctuations in the money supply and economic measures such as inflation, gross domestic product (GDP), and unemployment. The instability in this link gradually led to central banks placing less emphasis on monetary aggregates as an intermediate target.

Still, the money supply that the Fed and other central banks release into their economies clearly indicates their monetary policy, and M2 is a useful indicator of potential inflation when compared to GDP growth.

Understanding M0, M1, M2, and M3

The monetary aggregates categories are typically based on the liquidity and accessibility of various assets:

  • M0: Physical coins and banknotes in circulation along with currency reserves held by commercial banks at the central bank. M0 is also known as the monetary base and is the narrowest measure of money supply, over which central banks have the most control.
  • M1: Incorporates M0 and adds demand deposits, travelers’ checks, and other checkable deposits. These represent the most liquid forms of money, so M1 is typically used to gauge transactions in the economy.
  • M2: Adds savings deposits, money market securities, and mutual funds, and other time deposits to M1. This offers a broader view of the money supply, as it includes funds that are less immediately accessible than cash, checks, and direct deposits but are still liquid as they can be quickly converted to cash.
  • M3: Includes M2 along with large time deposits, institutional money market funds, and other larger liquid assets. As the broadest measure of money supply, M3 is used to assess the overall availability of funds in an economy.
  • M4: Includes M3 along with financial assets such as commercial paper and repurchase agreements. M4 is not as commonly used as the other four levels, and the definition can vary.

The various levels of money supply are used slightly differently by various central banks and organizations. For instance, the OECD collects data on M1 as “narrow money” used as a means of exchange and M3 as “broad money” to store value. The European Central Bank (ECB) defines M1 through M3. Meanwhile, the Fed stopped tracking M3 in the US in 2006.

How Monetary Aggregates Data is Used

Economists tend to track monetary aggregates to understand the links between monetary growth and other macroeconomic trends and gauge an economy’s financial stability. By reviewing M1 and M2 data, economists and investors can measure changes in money aggregates and how they relate to economic activity.

For instance, the increased money supply can cause prices to rise, and if the rate of price inflation becomes high, a central bank may step in to raise interest rates or otherwise halt the growth in supply.

The Fed uses money aggregates to measure how open-market operations, such as trading in Treasury securities, affect the economy. The US central bank’s legislative mandate is to set a monetary policy to support high employment, stable prices, and moderate long-term interest rates.

The Fed’s monetary policymaking arm, the Federal Open Market Committee (FOMC), sets targets for the growth of M2 and M3 monetary aggregates and relates them to the forecasts for unemployment, output growth, and inflation.

Monetary aggregates are watched closely by analysts and observers looking to predict Fed policy moves. In periods when the Fed aims to tightly control the aggregates’ growth rate, financial markets react to the weekly M1 data release.

The Fed can influence the growth of monetary aggregates by influencing short-term interest rates through the quantity of reserves held by depository institutions and the monetary base. Lower interest rates tend to determine private sector demand for monetary aggregates.

Temporary changes in aggregate output and employment and permanent price changes typically follow changes in monetary aggregates.

Real-World Example

The surge in inflation following the height of Covid-19 pandemic restrictions has fuelled the debate surrounding the quantity theory of money and its link to inflation. Excess money growth and high inflation rates were seen across developed and emerging economies.

For instance, in 2020-2022, the M1 rate in the euro area increased by over 30%. Inflation accelerated from 1.2% to 9.1% over the same period, peaking at 10.6% in October 2022.

https://www.european-inflation-tracker.com/supply/

“Some commentators saw the rise in inflation as proof of the validity of the quantity theory of money, arguing that nominal wages and prices could not keep on rising if money did not expand correspondingly. For others, the correlation was spurious and held little economic significance,” ECB Executive Board Member Isabel Schnabel said in a speech.

In early 2020, the Federal Reserve cut its policy interest rate to help ease credit conditions during the pandemic. Banks accommodating an increase in money demand drove an acceleration in M1.

https://fredblog.stlouisfed.org/2021/01/whats-behind-the-recent-surge-in-the-m1-money-supply/

The Bottom Line

Monetary aggregates are metrics that indicate the supply of money in an economy, providing insights into the liquidity and monetary conditions. Understanding the different categories, such as M0, M1, M2, and M3, allows economists, investors, and other analysts to assess money supply dynamics. As financial systems continue to evolve, so too will the methodologies and interpretations surrounding monetary aggregates.

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Nicole Willing

Nicole Willing has two decades of experience in writing and editing content on technology and finance. She has developed expertise in covering commodity, equity, and cryptocurrency markets, as well as the latest trends across the technology sector, from semiconductors to electric vehicles. Her background in reporting on developments in telecom networking equipment and services and industrial metals production gives her a unique perspective on the convergence of Internet-of-Things technologies and manufacturing.