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Know Your Numbers: Money Supply

Like clockwork, reports about new economic data keep coming, week after week, month after month. Some reports, like last week's release of the consumer price index, make headlines every time they become available. Others, on the other hand, rarely make it to the front page. Yet some of the numbers that hide in the background have the most interesting stories to tell about the economy.

For instance, every week, the Federal Reserve releases information about the monetary system in the United States. The most commonly discussed set of data is the release on the country's money supply. At first glance, the amount of money circulating in the economy may seem like a trivial fact; measures of real economic activity like the gross domestic product provide a much more concrete understanding of the economy's workings. However, when you think about it, the role money plays in making an economy work is invaluable. Without money, commerce as we know it would become nearly impossible. Understanding what the Fed's money supply figures mean, and the implications they have on the overall economy, is helpful to put other releases of economic data into the proper perspective.

The basic concept
As you might imagine, the Fed's money supply figures attempt to measure the amount of money within the economy. There are several different measures of money supply, each of which includes money in different forms. The narrowest measure of money supply, known as M0, provides information about how much physical cash there is in the economy; in other words, M0 includes the $51 that's currently in my wallet, the $10.25 in my daughter's piggy bank, and everyone else's currency and coins. M0 also includes certain deposits with the Federal Reserve, including certain reserves that private banks such as Fifth Third (Nasdaq: FITB  ) and First Horizon (NYSE: FHN  ) hold at the Fed. A broader measure called M1 includes everything in M0, but also adds in the total of all the money that people have on deposit in checking or other demand accounts, as well as instruments directly exchangeable for currency, such as travelers' checks. Another measure, known as M2, takes everything that was included in M1, then adds the total of all money in savings accounts, money market accounts, and certificates of deposit with balances of $100,000 or less. The broadest measure, M3, includes not only everything in M2, but also foreign bank deposits denominated in American currency, CDs greater than $100,000, institutional money market mutual funds, and repurchase agreements.

By looking at the amount of money that each of these measures includes, you can get a sense of the size of the overall economy. For instance, the current release of money supply data shows the latest level of M1 at about $1.35 trillion and M2 at around $6.9 trillion. Although M0 and M3 are not included in the weekly releases, other data releases suggest that M0 is probably between $750 billion and $800 billion, while M3 is likely somewhere around $11 trillion.

Economic implications
In simple terms, you can think of an economy as having two separate and distinct parts: the part that deals with the production and distribution of goods, services, and investments, and the part that determines the monetary value of those items. Unless both pieces of the economic puzzle are working correctly, the economy will generally suffer. If there are abundant goods and services, but no money to facilitate trade among people who own them, the economy is reduced to bartering transactions, which can severely limit the economic activity of diverse populations with different preferences and wishes. On the other hand, if there is an ample supply of money, but few or no goods or services to purchase, then no economic transactions can take place, and money becomes worthless as inflation runs rampant.

The Federal Reserve manages money supply in an effort to find a happy medium between economic growth and inflation. There are several ways in which the Fed takes steps to control the money supply. The method that most people know the best is the Fed's decisions about the levels of overnight lending rates like the federal funds rate and the discount rate. By raising short-term interest rates, the Fed discourages spending and tightens the money supply; lowering short-term rates has the opposite effect, discouraging saving and thereby increasing the money supply.

However, the Fed uses two other methods that aren't as well-known. First, the Fed regularly buys and sells Treasury securities on the open market. When the Fed buys a Treasury security, the cash it uses to purchase the security increases the amount of money in the overall economy. Similarly, if the Fed sells a Treasury security, the cash it receives for the security is removed from the system; the security isn't included in the money supply, but instead treated as an investment.

The second way the Fed can change money supply is by changing the levels of monetary reserves it requires all American banks to hold. By increasing the reserve requirements, the Fed can force banks to take money out of the economy. On the other hand, the Fed can also decrease required reserves, freeing up money for banks to lend and thereby increasing the available supply of money.

In evaluating the Fed's job of managing money supply, it's difficult to reach a consensus. Some commentators credit the Fed's management of money supply as a key element in the steady growth of the American economy over the past 25 years, while others blame the stock market bubble of the late 1990s and its subsequent burst in 2000 and 2001 on the excessive liquidity levels in the economy. In addition, economists disagree about what money supply goals are optimal for economic prosperity. Any target involves tradeoffs between those who benefit and those who suffer from a particular choice.

In summary, while money supply figures rarely make the news, they represent an essential element of the U.S. economy. By reviewing money supply data, you can watch how the Fed is responding to economic conditions and gain insight into how active central-bank policy has major impacts on a country's economy.

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You can learn more about managing your own money supply withMotley Fool GreenLight. The Fool's own personal finance service will give you great advice to make the most of your money. Check it out by beginning your 30-day trial today.

Fool contributor Dan Caplinger wishes he had as much control over his money supply as the Fed does. He doesn't own shares of any of the companies mentioned in this article. The Fool's disclosure policy helps you find objective answers.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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