- The money supply adds cash and deposits, and is measured with aggregates (M0–M3) according to liquidity.
- OM = m · BM: monetary base and multiplier (habits and reserves) determine its size.
- The central bank exerts influence through reserve requirements, the open market, and the discount window.
- More money supply tends to put pressure on prices (QTM), but money demand and the cycle matter.
The money supply It's one of those economic concepts that, although it sounds technical, affects everyday life: it influences prices, interest rates, and the ease with which families and businesses can access money. Essentially, we're talking about the total amount of money in circulation in an economy at a given time.
As a general idea, the money supply includes the cash in the hands of the public (banknotes and coins) and bank money that can be used almost like cash: demand deposits, checks, promissory notes, or certain money market instruments. If this amount gets out of control, inflationary pressures can arise; if it is scarce, financing becomes difficult and everyday transactions.
What exactly is the money supply and what does it include?
In operational terms, the money supply can be expressed as Money supply = Cash + Demand depositsThat is, the sum of cash held by families and businesses and bank deposits ready for spending. Many businesses accept payments by card or checkAnd that explains why deposits are part of what we call "money" because of their high liquidity.
It is important to distinguish between the monetary sector and the real sector of the economy. In the money market, supply and demand determine an equilibrium: the “price” of money is the interest rate and the “quantity” is the money balance. When the preference for liquidity increases, the equilibrium can shift, altering types and volume of money On circulation.
Therefore, there is no single way to measure money, because in developed economies there is a blurred boundary between assets that are pure money, quasi-money y fiat moneyThat is why different definitions or monetary aggregates are used that group assets by their degree of liquidity, from the most restrictive to the broadest.
Furthermore, central banks and the banking system have a decisive influence on its amount. The monetary authority It acts on the monetary base and the reserve requirements of banks, while the banks decide how much to lend and how much to hold as reserves, and the public determines how much. cash you wish to keep compared to what it deposits.
Monetary aggregates: M0, M1, M2, M3 (and M4)
To determine what is money and what is not, aggregates are used that classify assets according to their liquidity. Definitions vary depending on the country or monetary area, but the logic is common: the larger the aggregate, the more assets it includes.
M0 or monetary baseThe money supply consists of banknotes and coins in circulation plus bank reserves held at the central bank. This is the narrowest measure and, generally, the one the central bank controls most precisely. It is known as "high-powered" money because it is the basis for the distribution of currency through the banking system. expands the rest of the money.
M1Cash in circulation + demand deposits. This is money ready for immediate use. In many statistics, it is identified with the tighter monetary supply.
M2This includes M1 plus fixed-term deposits of up to two years and deposits available with up to three months' notice. It also includes highly liquid savings products, but these are not as immediate as demand deposits. Some Anglo-Saxon classifications mention... Deposit certificates of lesser amounts (for example, less than $100.000).
M3M2 adds money market instruments (money market fund shares), repurchase agreements (repos), and fixed-income securities with maturities of up to two years issued by monetary financial institutions. These are assets that closely resemble money due to their nature. high liquidity and low risk.
M4In some jurisdictions, it is used to include even less liquid quasi-money (such as certain promissory notes or other instruments). In the United States, the Federal Reserve stopped publishing M3 in 2006 and broader series M4s ceased to be widely used, although European definitions remain common.
| Financial asset | M0 | M1 | M2 | M3 |
|---|---|---|---|---|
| Cash in circulation (banknotes and coins) | x | x | x | x |
| Demand deposits | x | x | x | |
| Fixed-term deposits up to 2 years | x | x | ||
| Deposits with up to 3 months' notice | x | x | ||
| Temporary transfers (repos) | x | |||
| Values other than shares (≤2 years) | x | |||
| Money market fund holdings | x |
In the euro area, the European Central Bank defines M1, M2 and M3 Specifically: M1 (cash and demand deposits), M2 (M1 plus time deposits ≤2 years and deposits with notice ≤3 months), and M3 (M2 plus repos, money market funds and money market instruments, and debt ≤2 years). This system allows for comparison degrees of liquidity and assess the transmission of monetary policy.
Monetary base, multiplier and key formulas
The monetary base (MB) is the starting point of the system. It can be written as BM = E + Rwhere E is cash (in circulation and in bank vaults) and R is bank reserves at the central bank. From BM, through bank intermediation, the following is generated: money supply more espacious.
The relationship between base and supply can be summarized as follows: OM = m · BMwhere m is the money multiplier. A higher multiplier means that with the same base amount, a larger quantity of money is obtained in the economy. This relationship is crucial for understanding how a central bank measure... spreads through the financial system.
A common formulation of the multiplier is m = (1 + a) / (w + a)where a = E/D (currency in circulation as a percentage of deposits) and w = R/D (reserves as a percentage of deposits). If the public wants less cash (low a) and banks hold fewer relative reserves (low w), the multiplier increases and the money supply grows more for each base unit.
It is also common to see m expressed in other equivalent forms. In some manuals it is presented as m = (L + 1) / (R + L)where L approximates the relative preference for liquidity (cash versus deposits) and R represents the reserve requirement. The underlying message is the same: payment habits and reservation policy They determine how much "money mass" is generated.
Viewed from the asset breakdown, another useful identity is OM = E + D: money supply as a sum of cash held by the public (E) and deposits (D)This approach helps visualize the role of each component and understand why changes occur in ATMs, electronic payments, or cards They affect the preference for cash.
Who determines the money supply and how is it managed
The monetary base is jointly determined by the central bank, the banking system, and the public. The central bank decides the amount of the monetary base and sets conditions (e.g., reserve requirements), while commercial banks choose their own reserve requirements. voluntary reserves and its credit policy, and households and businesses distribute their wealth between cash and deposits.
The classic tools of the monetary authority are three: 1) open market operations (purchases and sales of assets to inject or drain liquidity), 2) modifications to the reserve requirement ratio (which alter the multiplier), and 3) the adjustment of the discount window or credit facility. Central banks such as the ECB or, to cite a Latin American example, Banxico, operate with these levers to influence the money supply and short-term interest rates.
When the monetary authority reduces reserve requirements, banks can lend out a larger portion of their deposits, which pushes the money supply upward. If, on the other hand, the cost of funding at the central bank rises, or toughens conditionsBanks will tend to be more cautious with credit and hold more reserves, containing monetary growth.
Although it is often said that the central bank “controls” the money supply, in practice its control is indirect and not absolutelyChanges in cash preference or credit demand can reinforce or attenuate the impact of official measures on the money supply.
Factors that drive OM in the short term
In the short term, some ratios are considered relatively stable. For example, the ratio cash/deposits It tends to move slowly because it depends on payment habits and financial infrastructure: more branches, ATMs and widespread use of cards reduce the need for cash.
The banking system holds a fraction of deposits as work? to meet cash withdrawals. Part of these reserves are mandatory (set by the central bank) and another part can be voluntary. If the interbank interest rate rises, banks may find it prudent to hold more reserves, increasing the reserve-to-deposit ratio and containing the multiplier.
Income levels and interest rates on deposits also influence how money is distributed between cash and accounts. With higher incomes, the demand for money increases, especially in the form of depositsIf banks offer attractive returns, households will prefer to deposit rather than hold cash, which tends to reduce the cash/deposit ratio.
In simplified terms: a reduction in the legal reserve requirement shifts the money supply curve to the right (more money supply), while an increase in the public's desire to hoard bills The multiplier contracts. These are opposing forces that, combined, explain the evolution of the OM.
Money supply, interest rates and inflation: theories and equation of exchange
The so-called equation of exchange summarizes the relationship between money and activity: Velocity × Money Supply = Real GDP × GDP DeflatorHere, velocity is the number of times per year that money changes hands (approximately GDP/Money Supply). If velocity and real output were stable, increases in the money supply would translate into more inflation.
The monetarist view argues for a direct link between the money supply and prices: if there is an excess supply of money, prices tend to rise. This idea is framed within the Quantitative Theory of Money, which underlines the role of money in determining the price level in the medium term.
The Keynesian perspective qualifies this relationship, especially in growing economies or those with spare capacity: expansions in the money supply can occur without immediately translating into inflation, because the demand for money and financial conditions can absorb that increase. In contemporary debates, approaches such as the Modern Monetary Theory (MMT) They introduce additional considerations regarding the role of the State and spending capacity.
In any case, the central bank monitors the interaction between monetary policy, activity, and inflation and adjusts its instruments to maintain the price stability without stifling growth. That's why sudden changes in the velocity of money or in the demand for liquid balances complicate the diagnosis.
Historical examples and recent signs
Economic history offers illustrative lessons. In 16th-century Spain, the influx of gold and silver from the New World increased the amount of metallic money. This increase in the most basic “money supply"These events contributed to the famous Price Revolution: the value of metal fell and the prices of goods and services rose across the board."
Another extreme case is the hyperinflation of interwar Germany. Faced with debt and production shortages, the resort to printing money skyrocketed the amount of currency and unleashed Uncontrolled price increases. The episode illustrates how exorbitant increases in the cost of living can quickly erode purchasing power.
In recent times, very strong expansions of aggregates such as M2 have been observed in large economies, with periods in which the money supply grew at unusual rates. For example, it has been noted that in the United States the money supply increased by around a +40% in a couple of yearsThis sparked debates about its effects on inflation and markets. The specific answer depends, among other things, on the demand for money and its velocity.
In practice, central banks calibrate their strategy using a broad dashboard: M1–M3 developments, credit conditions, inflation expectations, real activity, wages, and Interest rateNo single indicator tells the whole story, but tracking monetary aggregates provides useful signals.
Key components and determinants, with an operational overview
The fundamental elements of OM are two: the cash in the hands of the public (banknotes and coins outside the banking system) and bank deposits, which can function similarly to cash. The ratio between the two determines the daily liquidity of the economy.
Among the determining factors, the following stand out: monetary base (controlled by the central bank), the currency-to-deposit ratio (payment habits), and the reserve requirement (bank reserves). With less relative currency and a lower proportion of reserves, the multiplier increases and monetary policy expands more per unit of base.
The identity M = m · B (money supply equals multiplier times base) clearly summarizes how regulatory decisions (reserve requirements), banking behavior (voluntary reserves), and public choices (cash vs. deposits) determine the final outcome.
When the central bank wants to inject liquidity, it usually resorts to asset purchases (open market operations), which increase reserves and reduce short-term interest rates, encouraging lending. If it seeks to contain inflationary pressures, it may drain liquidity or raise the cost of financing for banks, slowing down the creation of bank money.
Related concepts and the money ecosystem
Understanding the OM is completed with some related notions. monetary aggregate It is the very concept of measurement (M1, M2, M3…), the monetary base speaks of the substrate from which the system starts, the multiplier The reserve requirement quantifies the expansion, the reserve requirement regulates banking prudence, the demand for money captures the preference for liquidity, and monetary policy is the set of instruments that the central bank applies to achieve its objectives.
- Monetary aggregate: definitions M0–M3/M4 according to liquidity.
- Monetary base: cash plus bank reserves.
- Money multiplier: relationship between OM and BM.
- Cash ratio y money demand: habits, reservations and types.
In day-to-day life, the transition to a society with less cash (electronic paymentsThe rise of digital wallets tends to reduce the use of banknotes and coins, affecting the cash-to-deposit ratio. Tools like EuroBillTracker reflect the interest in tracking cash circulation, but technological trends are pushing towards electronic payment methods. more digital.
Examining the money supply closely allows us to understand changes in inflation, interest rates, and credit. From M0 to M3, including the monetary base and the multiplier, the complete picture integrates central bank decisions, banking behavior, and public preferences; when these pieces fit together, the economy gains stability, and when they become misaligned, tensions appear that require well-calibrated monetary policy responses.
