Money Supply
Aggregate measures of money in the economy. Their relationship to inflation is theoretically clear, empirically unstable, and the subject of a long argument.
MadStockAlerts Research · Updated August 28, 2026
What to take away
- M1 and M2 are the commonly quoted aggregates, defined by liquidity.
- Bank reserves are not the same thing as money in circulation.
- The relationship between money growth and inflation has been unstable.
- Velocity is the residual that makes the identity hold, and it moves.
- Central banks largely stopped targeting these aggregates decades ago.
MAD Academy Training Video · 0:46
A Measure That Stopped Behaving
Money supply once tracked inflation closely enough to target, and the relationship broke down badly enough that policy abandoned it.
This lesson is part of a Stock Alerts + Tools plan.
The aggregates
| Measure | Contains |
|---|---|
| M1 | Currency in circulation, demand deposits and other liquid deposits |
| M2 | M1 plus savings deposits, small time deposits and retail money market funds |
| Bank reserves | Balances banks hold at the central bank. Not part of M1 or M2 |
The third row is the source of a persistent misunderstanding. Reserves created by asset purchases sit within the banking system and are not money in circulation, which is why very large increases in reserves did not produce a corresponding increase in M2.
The identity, and its residual
M x V = P x Q
- M is the money supply and V is the velocity at which it circulates
- P is the price level and Q is real output
- the identity is true by construction; V is defined as whatever makes it hold
The equation is an accounting identity rather than a theory. It becomes a theory only with an assumption that velocity is stable, and velocity has not been stable.
Scroll the chart sideways to see all of it.
- M2 growth
- Inflation
Why targeting was abandoned
Several central banks targeted money aggregates in the late 1970s and early 1980s. Financial innovation changed what counted as money, the relationship between the aggregates and nominal spending became unreliable, and the targets were abandoned in favour of interest rates.
One central banker's summary was that they did not abandon the aggregates; the aggregates abandoned them. The definitional boundary between money and other financial assets kept moving, which is the underlying problem.
What the series is still useful for
- A very large and rapid change is informative even where the relationship is unstable, because it is unusual.
- Contraction in M2 is rare historically and has coincided with periods of financial stress.
- It is a check on narratives about money creation, particularly claims that reserves are money in circulation.
- Over very long horizons, the relationship between money growth and inflation does hold.
Where money actually comes from
The textbook description has banks lending out deposits, constrained by a reserve requirement. The mechanism as central banks now describe it works the other way round.
- 1A bank makes a loanAnd simultaneously creates a deposit in the borrower's account.
- 2The deposit is new moneyIt was not transferred from anywhere; both sides of the bank's balance sheet grew.
- 3Reserves are obtained afterwardsTo meet settlement and any requirement, from the central bank or the market.
- 4The constraint is capital and demandRather than a pre-existing pool of deposits waiting to be lent.
This is why large increases in bank reserves did not produce corresponding increases in lending or in broad money. Reserves are not the raw material of lending, and the constraint that binds is capital, regulation and the demand for credit.
It also explains why broad money contracts when lending contracts: loans being repaid faster than new ones are made destroys deposits, which is a mechanical consequence rather than a policy decision.