M2 definition

What is M2?

M2 is a classification of money supply. It includes M1 – which is comprised of cash outside of the private banking system plus current account deposits – while also including capital in savings accounts, money market accounts and retail mutual funds, and time deposits of under $100,000.

M2 is a broader classification than M1 because it includes assets which are still highly liquid but that are not exclusively cash. M2 is mostly used as a classification for money supply in the eurozone and America; in the UK, the official designations are limited to M0 and M4.

Any increase in money supply is important information for forex traders, because increased supply could reduce the price of a currency – assuming demand remains the same.

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M2 and inflation

M2 is used as an indicator of possible increases or decreases in inflation levels. This is because it is a broader measure of the money supply in an economy than when compared with M1 – which only looks at money that is in the hands of the public.

As a result, M2 offers a more comprehensive overview of inflation levels because if the M2 monetary supply is increased, inflation could rise. Equally, if M2 supply is restricted by central banks, inflation could fall. However, it is generally accepted that there is a lag of between 12 to 18 months for inflation levels to respond to increased monetary supply.

Also, inflation will only rise if monetary supply is increased but economic output remains the same. If economic output increases alongside money supply, then inflation might not increase at all.

How do central banks influence M2?

Central banks can influence M2 supply by either issuing more money into the economy or by incentivising people to spend less. Quantitative easing is one way that a central bank can increase money supply and stimulate the economy.

To reduce the supply of M2 in an economy, a central bank might issue bonds or other government-backed securities which lenders can buy; in doing so, they loan the government money. This means that a central bank’s money reserves increase at the expense of the money available in the economy.

Central banks can also increase or decrease interest rates to influence M2. If interest rates are lower, borrowing will likely become more popular, which will increase the supply of money. Conversely, if interest rates rise, then the cost of borrowing will also go up which will deter people from taking out loans. This will decrease the M2 money supply in an economy.

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