M2

Published Apr 29, 2024

Definition of M2

M2 is a measure of the money supply that includes not only all of the physical currency in circulation and deposits in checking accounts (which comprise the M1 money supply), but also adds in savings deposits, small-time deposits (like certificates of deposit under $100,000), and money market mutual funds held by individuals. Essentially, M2 represents a broad view of the money supply, giving insight into the funds readily available to consumers for spending and saving.

Example

To understand M2 better, consider a scenario where individuals and businesses operate within an economy. John, an individual, has $1,000 in his checking account (part of M1) and an additional $5,000 in a savings account. Meanwhile, a small business owned by Sarah has $2,000 in checking and a $10,000 certificate of deposit maturing in six months.

Both the $5,000 in John’s savings account and the $10,000 certificate of deposit held by Sarah’s business, in addition to the funds in their checking accounts, are part of M2. This is because they are forms of money that, while not immediately accessible like the money in checking accounts, can relatively easily be converted into cash or checking deposits.

Why M2 Matters

M2 is a critical metric used by economists and policymakers to gauge the health of an economy and to make decisions regarding monetary policy. A rapidly increasing M2 supply can indicate that money is being pumped into the economy, which can spur economic growth but also has the potential to lead to inflation if the increase in money supply outpaces economic growth. Conversely, a slow growth rate in M2 can signal that the economy is in a downturn, leading policymakers to inject more money into the economy to stimulate growth.

By tracking the changes in M2, central banks, like the Federal Reserve in the United States, can adjust interest rates, buy or sell government bonds, and perform other actions to regulate the economy’s money supply, inflation, and overall economic activity.

Frequently Asked Questions (FAQ)

How does M2 relate to M1?

M1 is a subset of M2 and represents the most liquid forms of money, including currency in circulation and checkable deposits. In essence, all of the money counted in M1 is also part of M2, but M2 includes additional, less liquid forms of money, such as savings accounts and time deposits.

Why is M2 considered a better indicator of the economy than M1?

M2 is considered a more comprehensive indicator than M1 for assessing the money supply within an economy because it includes not only the money available for immediate spending but also the money that could potentially be converted into cash for spending. This broader measure gives a fuller picture of the financial resources available to the economy’s consumers and businesses, which can be a more accurate predictor of economic activity.

Can the growth of M2 predict inflation?

While a rapid increase in M2 can be one of the indicators of future inflation, predicting inflation involves considering many other factors, including economic output, unemployment rates, and external economic events. Economists and central banks use changes in M2 as one of several tools to forecast inflation, but it is not the sole determinant.

Tracking M2 is crucial for understanding the economic environment. Whether for conducting scholarly research, making investment decisions, or formulating monetary policy, M2 offers vital data on the liquidity available in the economy, serving as a foundational element for economic analysis and decision-making.