M2 Money Supply and Inflation

Money supply refers to the amount of money in circulation in an economy at a given time. It includes all the physical currency and coins in circulation, as well as bank deposits and other types of liquid assets. The money supply can be classified into different categories, based on the degree of liquidity and accessibility of the assets included.

One of the most commonly used measures of the money supply is M2. M2 is a broad measure of money supply that includes all the components of M1 (which consists of cash, checking accounts, and other demand deposits) plus other types of assets that are highly liquid and can be easily converted into cash, such as savings accounts, money market mutual funds, and small time deposits. M2 is often used by economists and policymakers to assess the health of the economy and make monetary policy decisions.

Inflation

The M2 money supply surged during the COVID-19 pandemic as a result of several factors. The federal government passed multiple stimulus packages that injected trillions of dollars into the economy, which led to an increase in the amount of money in circulation. Additionally, the pandemic caused a shift in consumer behavior as people spent less on services and more on goods, which increased demand for cash and other liquid assets. As a result, the M2 money supply grew at an unprecedented rate in 2020 and 2021, which raised concerns about potential inflationary pressures in the future at that time.

Turns out, the concerns were valid. Reminder - inflation is the rate at which the general level of prices for goods and services is rising, and it can have a significant impact on the purchasing power of consumers and the overall health of the economy. There are several ways in which changes in the M2 money supply can affect inflation:

• Increased money supply can lead to higher demand for goods and services. When there is more money in circulation, people have more purchasing power and are able to buy more goods and services. This increased demand can push up prices, leading to inflation.
• Increased money supply can lead to increased borrowing and lending. When there is more money available in the economy, it can be easier for individuals and businesses to obtain loans and credit. This can lead to increased spending and investment, which can also push up prices and contribute to inflation.
• Increased money supply can lead to increased speculation and investment in financial markets. When there is more money available, investors may be more willing to take risks and invest in stocks, bonds, and other financial instruments. This increased speculation and investment can drive up asset prices and contribute to inflation.

Dis-Inflation

On the other hand, a decrease in the M2 money supply can have the opposite effect on inflation. When there is less money in circulation, it can lead to decreased demand for goods and services, reduced borrowing and lending, and decreased speculation and investment in financial markets. This can lead to lower prices and lower inflation.

It's important to note that changes in the M2 money supply are not the only factor that can affect inflation. Other factors, such as changes in production costs, government policies, and international trade, can also play a role. However, the M2 money supply is a key indicator that economists and policymakers use to monitor inflation and make monetary policy decisions.

M2 of Late

After an incredibly steep increase in M2 supply as a result of the pandemic, the trend has started to flip as the Fed has tightened interest rates. M2 is actually decreasing, and has been since the summer of 2022. This will be an interesting development and a metric to watch as the US continues to wait and see if inflation will go back down to the Fed's target of 2% any time soon.

Bottom Line

In conclusion, the M2 money supply is a measure of the amount of money in circulation in an economy that includes a variety of highly liquid assets. Changes in the M2 money supply can have a significant impact on inflation, as increased money supply can lead to increased demand for goods and services, increased borrowing and lending, and increased speculation and investment in financial markets. Understanding the relationship between M2 money supply and inflation is important for economists, policymakers, and anyone interested in the health of the economy.