Is the inflation rate more closely related to M1 growth or M2 growth?
The correct answer and explanation is:
The inflation rate is generally more closely related to M2 growth than M1 growth.
Explanation:
M1 and M2 are categories of the money supply used to measure the amount of money circulating in the economy, but they differ in their components and scope:
- M1 includes the most liquid forms of money: physical currency, demand deposits, traveler’s checks, and other checkable deposits.
- M2 includes everything in M1 plus less liquid assets like savings accounts, time deposits under $100,000, and retail money market mutual funds.
Inflation, defined as the general rise in prices, is influenced by the overall money supply because more money chasing the same amount of goods and services tends to bid up prices. However, the connection between money supply and inflation depends on how broadly money supply is measured and how that money moves through the economy.
Why M2 is more closely related to inflation than M1:
- Broader measure of money available to spend: M2 captures a larger portion of money that households and businesses can use relatively quickly. Savings accounts and time deposits, though less liquid than checking accounts, can be converted into spending money fairly easily. When M2 grows rapidly, it suggests that the overall liquidity in the economy is increasing, which can lead to greater demand and higher prices.
- Velocity and liquidity considerations: M1 captures only very liquid money and can be quite volatile as people move money in and out of checking accounts. M2 is a more stable indicator of total money available for consumption and investment, reflecting broader economic behavior and trends.
- Empirical evidence: Historical data shows stronger correlations between M2 growth rates and inflation trends than between M1 growth and inflation. This is because M2 reflects the money supply that influences aggregate demand more comprehensively.
In sum, while M1 growth provides insight into immediate transactional money, M2’s broader scope makes it a better predictor and correlate of inflationary pressures in an economy. Economists and policymakers often monitor M2 when assessing inflation risks.