Monetary aggregates are a group of measurements of the supply of money in the economy. They are used by the creators of monetary policy to estimate the supply and demand in the economy. These estimates allow policymakers to assess the monetary side of the economy and evaluate any changes they choose to implement.
The money that is in circulation is held in various forms. Investors want to stay away from holding cash or its equivalents because it is a dominated asset, or an asset that has negative returns. This is due to inflation, which constantly decreases the real value of non-interest-bearing accounts. As a result, investors hold some money in interest-bearing accounts, but they must still have some cash on hand for everyday transactions. Depending on the form in which people hold their money, the actual amount of money in circulation changes because banks must only hold a percentage of their investments in reserves; each deposit allows the institution to make investments that cost a larger amount than the money in the deposit.
Economic analysts keep track of five monetary aggregates. M0 is the amount of circulating cash and coins. The M1 aggregate is M0 with demand deposits, like checking accounts, added to it. M2 adds small-scale savings accounts, money market accounts, time deposits and repurchase agreements, and M3 adds the large-scale version of those holdings. The most inclusive aggregate, L, also counts funds tied up in assets such as short-term bonds.
The aggregate measurements are not interchangeable; they vary in that each successive aggregate is more inclusive but less liquid than the last. The relevance of specific monetary aggregates changes over time according to the characteristics of the economy. For example, the US Federal Reserve used to track M0 through M3, but it ceased reporting M3 in 2006 in response to an increased focus on liquidity. Similarly, M0 is too narrow to be useful, so investors commonly ignore it and focus on the M1 and M2 aggregates.
Investors track changes in monetary aggregates to gain insight into the state of the economy. If the aggregates show large, consistent increases, people expect that inflation will rise because the increased money supply will outpace increases in output. When a larger supply of money is available for the same pool of interactions, prices increase.
Monetary aggregates are also important to the financial policymakers in any country. Governments have two ways of influencing the economy: fiscal policy and monetary policy. Fiscal policy is based on influencing output using government spending. Monetary policy makes changes in the money supply to affect the economy. To enable the use of monetary policy, authorities must estimate and track the money supply in the form of monetary aggregates.