Money Supply Dynamics: M1, M2 & The Velocity of Money
How commercial banks create money through fractional lending, M2 expansion vs. contraction, and the Equation of Exchange ($MV=PY$).
1. Defining the Monetary Aggregates
The Federal Reserve tracks total money circulating in the economy through tiered monetary aggregates:
- M1: The most liquid transactional money — physical currency in circulation, demand deposits (checking accounts), and other liquid deposits.
- M2: M1 plus savings deposits, small-denomination time deposits (CDs < $100k), and retail money market funds.
2. How Money Is Actually Created: The Fractional Banking Multiplier
A common misconception is that the Federal Reserve prints all money directly. In reality, modern money is overwhelmingly created by commercial banks through fractional reserve lending. When a commercial bank issues a mortgage or commercial loan, it simultaneously creates a new deposit in the borrower's account — expanding M2 money supply.
3. The Velocity of Money Equation
The transmission of money supply into inflation and economic output is governed by the Equation of Exchange:
Even massive M2 expansion will not generate runaway inflation if the Velocity of Money ($V$) collapses due to hoarding, deleveraging, or economic paralysis.