Definition
The money supply is the total stock of money in circulation within an economy at a given point in time. It includes physical currency (coins and notes) plus the deposits held in commercial banks that can be withdrawn on demand or converted to cash. Economists track the money supply through aggregates — M0 (currency in circulation), M1 (M0 plus demand deposits), M2 (M1 plus savings accounts and money market funds) — because different components respond differently to policy and affect spending behavior differently.
The money supply is not a fixed endowment handed to an economy. It expands when commercial banks make loans (creating new deposits) and contracts when loans are repaid. Central banks influence this process indirectly through reserve requirements, the policy interest rate, and open market operations — buying or selling government securities to add or drain reserves from the banking system.
Why it matters
How money is created and destroyed
The components of money supply
Base money (M0)
M0 — also called "high-powered money" or the monetary base — consists of currency in circulation plus bank reserves held at the central bank. Only the central bank can create or destroy base money. It does so through open market operations: buying government securities adds reserves to the banking system; selling them removes reserves.
Broad money (M1 and M2)
Most money in a modern economy is not central bank money — it is commercial bank money: deposits that exist as accounting entries, created whenever a bank makes a loan. When a bank lends $10,000, it does not hand over vault cash; it credits the borrower's deposit account with $10,000. New money appears on both sides of the bank's balance sheet simultaneously. M1 (demand deposits + currency) and M2 (M1 + savings deposits + money market funds) capture this broader universe.
Money supply and inflation
The quantity theory of money — MV = PQ — offers the most direct link between money supply and prices. If velocity (V, the rate at which money changes hands) and real output (Q) are stable, a rise in M must produce a proportional rise in P (the price level). This is why sustained, above-output money supply growth reliably generates inflation over medium and long horizons.
The relationship is less tight in the short run. Banks can sit on reserves without lending. Velocity can fall. Output can rise to absorb new money. But over long horizons — across enough countries and enough years — the correlation between money supply growth and inflation is one of the most robust facts in macroeconomics.