Monetary Aggregates

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21 Aug, 2024

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Monetary aggregates are the measures of money supply in an economy. Also known as money aggregates, common categories include M0, M1, M2, M3, and M4. These aggregates aim to help central banks manage the money supply in the economy and achieve their policy goals.

The monetary aggregates include liquid cash and cash equivalents like bank deposits, investments, commercial papers, etc. These aggregates are classified based on the degree of liquidity of their constituents. Understanding money supply and aggregates can help the government control the economy and enact necessary policies. Moreover, these aggregates help calculate financial and economic stability and growth.

What Are Monetary Aggregates?

The monetary aggregate refers to the constituting elements that can help measure the money supply in an economy.
Also known as money aggregates, governments and central banks keep an eye on them to study them and make predictions. They also help in decision-making and laying out policies.
There are five main types of monetary aggregates – M0, M1, M2, M3, and M4. Each aggregate constitutes financial instruments of varying liquidity.
Despite these five types, each government pays attention only to one or two most important categories affecting their economy.

Monetary Aggregates Explained

The monetary aggregate refers to essential parameters in the money supply. So first, let's gain a brief understanding of the latter. Money supply refers to the circulation of cash and its equivalents in the economy. But, it is the money held in hand, bank accounts, investments, and other assets. Therefore, the supply should be optimal. Otherwise, there could be macroeconomic issues.

For instance, if the supply is high, people will have more money to spend, thus increasing demand. As a result, demand will increase price levels leading to inflation, a significant concern for the central bank. Similarly, if the money supply is less, people have less money which stifles their ability to buy essential commodities. Furthermore, this will slow down the economy and harm the country. Hence, the relationship between monetary aggregate and inflation can be complex. Therefore, central banks use monetary policy tools, such as adjusting interest rates and reserve requirements, to control the money supply's growth rate and manage inflation..

Given the issue's sensitivity, the government regularly checks the money supply. One of the best methods to do this is via the measures of monetary aggregates. Using this parameter, the central bank can understand how much money is locked under various liquidity levels.

Therefore, this will help them employ various measures under the monetary policy. So, they can implement a contractionary policy during high inflation to reduce the money supply and control the aggregates. Similarly, they can introduce an expansionary policy to increase money circulation during bad deflation. Furthermore, the central bank uses various tools to control the monetary aggregate. These tools include,

Types

These aggregates can be classified on their narrowness or breadth. Therefore, monetary aggregates can be classified as:

M0 or the monetary base: This is the narrowest aggregate and includes the amount of liquid cash in circulation in the form of currency notes, coins, cash or bank reserves, etc. These are highly liquid equivalents.
M1: Also known as narrow money, it includes M0 aggregates and demand deposits held by individuals and businesses in commercial banks.
M2: M2 contains M1 aggregates, marketable securities, saving deposits, time deposits, and less liquid bank deposits.
M3: Known as broad money, this includes M2 aggregates and money market funds such as commercial papers, mutual funds, institutional money market funds, etc.
M4: This is the final measure constituting M3 aggregates and less liquid funds held outside commercial banks.

Despite this classification, different countries adopt different measures of monetary aggregates. For example, in the U.S., the Federal Reserve only considers M0, M1, and M2. However, financial analysts in the country sometimes think of M3 too.

Examples

Let us understand the concept better with the help of an example.

Example #1

Consider an example of the M1 monetary aggregate for a hypothetical economy. Suppose the total amount of currency in circulation in this economy is $500 billion. Furthermore, the total amount of demand deposits and other checkable deposits held by individuals and businesses in commercial banks is $1.5 trillion. Hence, the M1 money supply for this economy would be $2 trillion ($500 billion currency in circulation + $1.5 trillion demand deposits and other checkable deposits).

Therefore, if the central bank of this economy wanted to increase the growth rate of the money supply, this can be done by implementing policies to encourage banks to lend more money and increase the number of demand deposits in the economy. On the other hand, if the central bank wants to decrease the growth rate of the money supply. It reduces money circulation or encourages individuals and businesses to hold their money in less liquid assets, such as saving accounts or time deposits.

Example #2

The money supply in the United States is decreasing, and some economists believe it is a good sign against inflation. For example, the M2 monetary aggregate – the Federal Reserve's primary measure declined by $147.4 billion for the first time. M2 had decreased for five months to $21.2 trillion in December 2022. Besides, the M2 had been high since March 2020, when the Federal Reserve slashed rates in response to the pandemic and marked a 40% increase corresponding to $6.3 trillion. However, considering that there has been a $300 billion decrease in money market funds from a year ago, there might be good news awaiting.

Difference Between Monetary And Liquidity Aggregates

Monetary aggregate and liquidity aggregate are two different ways of measuring the amount of money or financial assets in an economy. Let us look through the difference between the two.

Monetary Aggregate	Liquidity Aggregate
It refers to a broad measure of the money supply that includes various types of money and financial assets	Liquid aggregate refers to the financial investments that can be easily converted to cash.
Includes less liquid assets such as savings deposits, time deposits, and institutional money market funds	These involves highly liquid assets such as cash, checking deposits, and money market instruments
Used to track the overall growth of the money supply and to measure the effectiveness of the monetary policy	It is used to assess the liquidity position of individuals, businesses, and financial institutions
M1, M2, M3 are commonly used measures	Examples of liquid aggregate include cash, checking accounts, and short-term, low-risk debt securities’

Frequently Asked Questions (FAQs)

1. Why are monetary aggregates important?

These aggregates are essential for several reasons to include,
- The measure of the money supply
- Indicator of economic activity
- Tool for implementing monetary policy
- Forecasting
- Comparison across countries

2. What is formula of monetary aggregate?

The formula for calculating these aggregates depends on the specific aggregate being calculated. For instance, M1 is calculated by adding currency in circulation to checkable deposits, while M2 is calculated by adding savings, time, and money market deposit accounts to M1.

3. How do changes in monetary aggregates affect the economy?

Changes in these aggregates can affect the economy in several ways. For instance, an increase in the money supply can lead to inflation if it outpaces the growth of the economy's actual output, while a decrease in the money supply can lead to a recession or deflation. Therefore, it significantly affects the economy, like inflation, interest rates, economic growth, and exchange rates.