What is M2 Money Supply and Why It Matters for Inflation and Deflation

We’ve never seen money supply fall. Granted we’ve never seen money supply rise 26% over a year either.

What is M2 Money Supply?

M2 money supply is a way of measuring how much money there is in a country’s economy. It includes cash, checking deposits, and other types of deposits that are easily turned into cash, such as certificates of deposit (CDs) and retail money market funds. M2 money supply does not include retirement account balances or time deposits above $100,000, because they are harder to access or use as money.

If the M2 money supply grows too fast, it can cause inflation to rise, which means people’s money can buy less, but also means interest rates have to rise to incentivize saving and investing. If the M2 money supply grows too slow, it can cause interest rates to fall, which means people have less incentive to save or invest their money.

Why is Negative M2 Money Supply Important?

We’ve never seen this before. The economic theory around inflation is that there are too many dollars chasing to few goods. Johnny is selling 20 apples and the people waiting in line wanting apples have $20 in total, making Johnny’s apples $1/apple, when those people suddenly have $40 his price rises to $2/apple.

What happens when the people waiting in line suddenly have only $15 dollars, does Johnny continue to sell at $1 knowing everyone can’t buy his apples, or does he lower his prices to $0.75 to sell of his apples?

This is essentially too few dollars chasing to many goods, otherwise known as deflation.

Inflation Versus Deflation

Inflation is a good thing at steady amounts. Whether inflation is 2% or 5% doesn’t much matter, in my opinion. What does matter is it’s not going from 2% to 8% back to 5%. As long as it remains constant we are fine.

Inflation stimulates economic growth. Companies can increase revenues, and profits. Maintain margins and grow. Leading to greater wealth for shareholders of those companies. It allows GDP to rise at a constant steady state, and allows the government to issue more and more debt, in moderation, because old debt is getting inflated away.

Deflation on the other hand, causes businesses to lose revenues, and thus to maintain profits and margins, needs to cut costs, and usually does so in the form of layoffs. Leading to customers not purchasing as much and continuing to cause more layoffs. Governments would also have to constricted budgets and the need pay off debt now because their balances are rising with deflation. This was on an extreme scale with the great depression.

Could Declining M2 Money Supply Cause Deflation?

My guess is that if it is allowed to spin out of control it could, but I don’t believe it has the same effect as increasing money has on inflation.

In the words of Milton Friedman, “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

So by the same measure a more rapid decrease in the quantity of money than in output should produce deflation. Similar to how Johnny’s apples went from $1/apple to $0.75/apple because the amount of money shrank.

However, this is theory. In practice inflation and deflation theory is not perfect. The behavioral side, the side that actually looks at how people interact in these scenarios, tells us that it is fluid with human emotion.

When humans believe prices will go up, inflation goes up because they start buying more stuff before prices go up. When humans believe prices will go down, deflation sets in because they wait to buy more stuff, when it becomes cheaper.

So is it a function of money supply or a function of human emotion and behavior? It’s probably a little bit of both and it is important to understand that.

Ultimately rates will come back down and stimulate spending which would push the amount of dollar chasing goods higher again to stabilize inflation.