What Is M2 Money Supply, And How Is It Used?

by Himmat
@liquidamber_h

November 22, 2022

2. What's included in M2 Money Supply But Not M1?

M2 consists of M1, plus balace in retail money market funds, and small-denomination time deposits.

Small time deposits, and retail money market funds are not in M1.

3. M2 Money Supply Chart

The Federal Reserve System provides the most reliable chart for M2 Money Supply over time.

Data is updated on a monthly basis.

4. Why The Fed Cares About M2 Money

M2 is used as an indicator of possible increases or decreases in inflation levels.

The idea is: the less money that exists in the world — the less demand for goods there will have to be, and prices should fall.

(Note: M1 and M2 are much more comparable now. In May 2020, the Federal Reserve changed the definition of M1 to include "other liquid deposits and savings.")

5. How Hedge Funds Use M2

Money managers, unlike economists, have skin in the game — they are punished severely when they're wrong.

Thus, it can be interesting to see how market participants make use of M2 Money Supply data.

Hedgeye uses the rate of change of M2 Money as a clue to measure the liquidity in financial markets as a whole.

Liquidity is a measure of availability — in this case, an availability of money and credit — so it makes sense that a measure of M2 money supply would be a great starting point for the liquidity of money and credit!

UK M2 decelerates from -6.2% YoY to -9.3% YoY in August and has been negative since May. pic.twitter.com/KSBvmi6DHN

— Hedgeye (@Hedgeye) October 3, 2022

6. Limitations of M2

The global dollar economy is an open system with many variables, including political ones outside the realm of economics.

M2 tells us a lot, but it's only one datapoint — with its own limitations.

M2, and even M3, don't include money-like assets such as short-duration bonds or reverse repo balances, for example.

Nor does it include money that could be accessed by fully-utilizing credit cards.

7. What Makes M2 Money Go Up Or Down?

M2 increases when a commercial bank makes a loan by creating a liability deposit account/entry for that amount, and a matching entry in its loan book. Creating that deposit money increases M1 (and M2)

In 2020 and 2021, the U.S. increased M2 by issuing stimulus checks (fiscal policy).

Central banks, however, can change M2 supply through monetary policy:

1. Quantitative tightening — as long as bonds are purchased using bank deposits (which are in M2), rather than from Reverse Repo (which are outside of M2).
2. Increasing interest rates — because bankers lend more conservatively, since only high-quality businesses will be able to afford expensive interest payments.
3. Decreasing interest rates — because bankers lend more freely, and since money is created when banks make loans, this increases the money supply.

8. Credit Card Balances Are Not Included In M2

Credit card balances are not included in M2.

So, if you are tracking broad liquidity, be sure to check the FRED data on credit cards, & bank loans.

9. What Near Monies Are Included In The M2 Money Supply?

Near money refers to savings deposits, money market balances, and small-time deposits.

9. M1 Differs From M2

M1 money supply includes those monies that are very liquid such as cash, checkable (demand) deposits, and traveler's checks.

M2 includes "small time deposits," which are not included in M1.

M2 is therefore less liquid than M1.

As you can see below, M2 is 95% the same as M1.

10. Why Did M1 Increase In 2020?

After May 2020, the Federal Reserve changed the definition of M1 and M2 to include money market funds.

Since then, M1 and M2 (and even M2) have been less distinct from one another.