M3 or not M3?

In response to a post earlier this week on M2 and inflation, one of our readers asks why I looked at M2 rather than M3. Here’s the answer.

Economists define “money” as an asset that is used to pay for transactions. Thus, for example, we don’t include your credit card in any measure of the money supply, because it’s not an asset. Having a credit card doesn’t make you rich– I hope I’m not the first person to tell you that. We likewise don’t count holdings of stock equity, because you can only use your stock wealth to buy your groceries if you first convert it into another asset. The quantity of money in circulation would be of economic interest insofar as it bears a stable relation to the dollar value of transactions that get undertaken.

Certainly money does include the green cash you hold along with any account you can write a check on, as well as items such as travelers checks or a savings account whose funds get automatically transferred to cover checks you may write. All these assets get added together to calculate the measure of the money supply known as M1.

But even a savings account that is not automatically transferred to checkable funds can be accessed much more easily than stock equity for purposes of making a purchase, as can retail money market mutual funds. For many people, these accounts function very similarly to the way conventional checking accounts used to, and such items get added to M1 to arrive at the broader money supply measure M2.

And then there is the now-no-longer-published M3. This added to M2 a number of liquid assets used by large institutions or wealthy investors, such as institutional money market funds, time deposits in excess of $100,000 with penalty for early withdrawal, repurchase liabilities of depository institutions, and dollar-denominated accounts held by someone with a U.S. address at certain foreign banks or foreign branches of U.S. banks.

I have to confess that in a quarter century of teaching and research, I never had any occasion to make use of M3. It always seemed to me that this unambiguously failed the definition of an asset that is used to pay for transactions. If you’re going to include such assets in your concept of “money”, why stop there? Don’t you want to include T-bills as well, and if them, why not Treasury bonds? You have to stop somewhere, and I always stopped with M1 or M2.

In addition, a primary reason for focusing on the money supply for policy purposes is that it’s a magnitude controlled by the government. The physical dollar bills are of course printed by the government, and a bank that issues checking accounts must hold credits that could be used to obtain physical dollars (known as Federal Reserve deposits) in a certain proportion to the value of the outstanding checkable deposits. However, it is unclear how the government is supposed to control the M3 components. Balances at foreign banks, for example, are clearly outside the control of the U.S. government.

I was thus a bit surprised at the brou-ha-ha that erupted over the Fed’s decision to discontinue requiring banks to provide the data that was used to calculate some components of M3. These concerns continue to bubble up in comments from Econbrowser readers.

I’m aware of no evidence suggesting that M3 helps predict U.S. inflation or economic activity better than M2. In my previous post I noted the strong correlation over 1875-1985 between 10-year averages of M2 growth and nominal GDP growth, and the following slightly weaker correlation over the last 35 years:


Here, for comparison, is the analogous picture for M3. Insofar as M2 and M3 have differed, M2 seems to have had a closer correspondence with economic activity.


Of course, the intriguing thing is that big surge in M3 growth relative to M2 of the last few years, which raises the possibility in some people’s minds that U.S. inflation will suddenly start being fueled by eurodollars and large time deposits.

But if that happens, it will be something new.

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24 thoughts on “M3 or not M3?

  1. XRay

    Since it is aggregate demand (a flow) that we relate in theory to price increases-prices increase because supply cannot adjust in the short run to increases in demand- would it not be more correct to include the overdraft limits on checking accounts as well as credit card drawal limits to take into account the amount of purchasing power that can come onto markets in a short time?

  2. Barry Ritholtz

    The main complaint about the cancelling of M3 reporting was simply: “Why?”
    M3 presented a clean historical data series — sans hedonics, substitutions, or seasonal adjustments — that is a rare and valuable thing.
    The actual costs of compliling M3 were de minimus. Its a loss to not have it.

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  4. odograph

    “time deposits in excess of $100,000 with penalty for early withdrawal”
    The part over 100K or the whole thing? It strikes me that a lot of 100K cds are out there creeping up, until they get reballanced.

  5. eTrader

    you wrote:
    “Economists define “money” as an asset that is used to pay for transactions.”

    “We likewise don’t count holdings of stock equity, because you can only use your stock wealth to buy your groceries if you first convert it into another asset.”
    PERHAPS economists ought to reexamine the convertibility of stock equity assets to spendable cash. What once took days and involved fees of hundreds of dollars can now be done in minutes for very few dollars.
    An eTrade account with enough in it qualifies for pretty low transaction fees. Cash pools into Money Market. One can write eTrade checks at any time.
    Such delays as eTrade imposes on access to cash are mostly arbitrary.

  6. SociallyDead

    I agree with your comment that economists need to consider the effect of stock tarding acounts with high liquidity, but what percentage of people in the U.S. actually have such an account? Could the number be negligible, compared to the size of M2?
    Prof. Hamilton,
    Good work and concise writing as as usual! By the way, where do you find these data sets? I would appreciate if you also post information/link about the source with your article.

  7. kharris

    The reasoning laid out here is clear and reasonable, but also entirely formal. To my knowledge, most objections to dropping M3 have nothing to do with “moneyness” or the responsibility of government for the magnitude of the stuff being measured. Objections are more practical. If rubbing M3 up against other data series proves revealing, then we need M3. The Fed’s argument is that you don’t learn much by rubbing M3 against other series. Critics think you do learn from that effort.

  8. Aaron Krowne

    Thanks for the reply. I have serious misgivings about how you draw the line between money and credit.

    Or maybe you aren’t drawing the line… but based on your own remarks, we’re coming to a different set of conclusions.

    Firstly, I assume you have noticed that hundreds of billions of dollars of consumption in the US per year rest on home equity extraction. In other words, people are writing checks on their houses. So mortgages are money.

    I routinely write checks on my credit card (though not to stay afloat, as many others do). The heritage foundation recently published a piece “debunking” poverty that made its case by showing that the poor spend far more than their income. Someone is doing a lot of “check-writing” on credit. So, credit cards are money.

    Whether this is all sustainable, of course, is another matter.

    My point is: the lines are not as clean as the textbooks would seem to assume. Maybe regular folks have a different interpretation of money than economists.

    I think there is a huge question right now of how to interpret money, which has ramifications for the understanding of the economy in the short term vs. the long term, and asset bubbles vs. broad-based inflation.

    My worry is that the economy has been based on so much “M3 money” that when it is taken away, only a severe downturn could be the result. It seems obvious to me that more of the population is reaching further that ever before into this “fake” money for everyday living–not for investing/speculation.

    By the way, I’m not sure looking at contemporaneous GDP vs. M2 and M3 is the end of the analysis. What if the results of M3-pumping don’t show up in GDP… at least not present GDP? What if they show up in, say, housing prices? To some (like me) this has very real ramifications. And there is that nagging question of what happened around ’95. A change in policy? A change in how the markets responded? A change in how the statistical series were calculated?

  9. kurt tietjen

    2 things would be interesting to further analyze. First, is there a longer term analysis comparing GDP to both M2 and M3? I’d be curious to see how closely the curves coincide to each other prior to 1970.
    Second, I’m curious why there is such a departure during the formation and implosion of the tech-bubble from ’95 to ’01 [with obvious ramifications to the trends even today].

  10. Barkley Rosser

    I agree that it would have been useful to keep tracking M3.
    It is essentially a matter of judgment and the stability of the relevant velocity which should be watched (or controlled) most closely. For decades the focus was on M1, then it shifted more to M2 as the nature of the deposits changed.
    In many countries policymakers do focus on M3. Of course how these are defined will also vary across countries. Sometimes even within a country they may not know what they are doing. One of my favorite anecdotes is that in the early 1980s the Saudi Arabian Monetary Agency (SAMA) had two different series for M3 published in different sections of its annual reports. It seemed that different subsections of SAMA were using different definitions.

  11. knzn

    “Having a credit card doesn’t make you rich” Money doesn’t make you rich either, if you just borrow it. I’m puzzled as to why anyone would expect any measure of money to have a stable relation to the dollar value of transactions today, given that most transactions are plastic. Before I got a better job and refinanced my mortgage, I used to let my credit card debts run: money (except for the monthly minimum payments) had nothing to do with my transactions. When I refinanced my mortgage and paid off the credit cards, the money (representing several years of expenses) appeared and disappeared like a flash of lightning. Since then, I’ve been paying off credit card purchases each month and also accumulating cash, which I’ve been meaning to invest but haven’t gotten around to it. When I do, I suppose I’ll put it in an investment account that lets me write checks. Am I very atypical in the lack of relation between my transactions and my money balances?

  12. algernon

    “This added to M2 a number of liquid assets used by large institutions or wealthy investors, such as institutional money market funds, time deposits in excess of $100,000 with penalty for early withdrawal, repurchase liabilities of depository institutions, and dollar-denominated accounts held by someone with a U.S. address at certain foreign banks or foreign branches of U.S. banks.”
    It is not clear to me whether any of these categories can be spent without being converted to M1/2. Institurional money market funds certainly sound as if they could be spent before showing up as M1/2.
    It is certainly a question of interest why M3 should grow so much faster than M2. Don’t you think.

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  14. touche

    I routinely write checks on my credit card
    I never do that because they tack on a hefty fee. I do, however, write checks on my home equity account for large purchases to tide me over until I can liquidate an investment. These lines of credit have blurred the distinction between cash and assets such as stocks, bonds and mutual funds.

  15. knzn

    Although, it occurs to me that the credit card issuers need to use actual money (certainly some form of M2) to honor your checks or to pay my vendors. So it’s not as if money is no longer necessary in order to get transactions done. It’s just that money no longer needs to concern the end-user. If the relationship between money and transactions at the level of the credit card issuer remains consistent over time, then I suppose you might get a new stable relationship between money and income. But it seems to me the relationship is going to be extremely noisy, because end-users like me will sometimes hold large amounts of money for no good reason (e.g., because we haven’t gotten around to investing it), and if a lot of people do stuff like that, it must swamp the efficient balances that need to be maintained by credit card issuers and other people who really use money for transactions.

  16. Steve Waldman

    I’m among those (like, for example, eTrader above) who think that traditional money supply measures are growing obsolete due the the increasing ease with which nearly any asset can be monetized. I put up a semi-formal presentation a while back of how I think this plays out; I’d certainly be interested in any feedback. (You’ll have to click past the “Read more” link to get to the meat of the post.)

    Thanks as always to JDH and MC for a very thoughtful and thought-provoking blog.

  17. spencer

    I use MZM as I think it comes closer to measuring the concept that M1 and M2 use
    to measure.
    In particular, I use real MZM as a leading indicator of the stock market PE — what M 1
    use to be — and find it to be very good at that.

  18. Aaron Krowne

    Steve Waldman:

    You seem to have precisely captured my concerns (as well as what is obvious to me about how the financial world works these days). In particular, your claim about the new importance of asset values is one I agree with, and think is central.

    Let me also add, that in terms of what M3 vs. M2 does measure, I believe that repo agreements and eurodollars are among them. As I understand it, these are precisely the sort of things we would expect to see expand rapidly in the case of an attempt by the Fed to inject liquidity into the system.

  19. The Prudent Investor

    I am still left with the question as to why there is such a big difference in the importance of M3 for the Fed’s and the ECB’s monetary policy. The ECB has the mandate to keep inflation below a maximum of 2% AND restrict M3 growth to the set target rate of 4%. The money supply target has been overshot since the inception of the Euro, hovering at more than 8% since almost two years. The inflation target cannot be met since the beginning of 2006. The situation does not get better with European CPI certainly erring on the low side.
    Has anybody come across some literature that compares the monetary policy strategies on both sides of the Atlantic? Both strategies run into problems and increasingly fail to meet their targets.

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  21. pat

    Nice writing and good explanations on M1/2/3.
    But I am still on the camp that M3 should be continued. As kharris says: “If rubbing M3 up against other data series proves revealing, then we need M3. The Fed’s argument is that you don’t learn much by rubbing M3 against other series. Critics think you do learn from that effort.” In addition, if the Fed applies some foreward looking, it is not that hard to imagine that there is at least a possibility that with all sorts of financial innovations, M3 will become more relevant as time goes by. So why destroy a perfect long time series now?

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