Generally speaking, inflation occurs if M2 money supply expands faster than the rate of productive growth in the overall economy. This means prices are higher than they otherwise would have been. It's important to distinguish between certain components of M2, however. Cash and checking account balances affect inflation. Imperfectly liquid claims to money, such as money market mutual funds and traveler's checks, are less significant to the relationship.

Defining M2

The Federal Reserve lists the following components in its M2 money supply: currency, nonbank travelers checks, demand deposit account balances, other checkable deposits, savings deposits and money market deposits at commercial banks or thrifts, small-time deposits, and retail money funds. The Fed and many economists consider these items to be money and money substitutes.

Money and Direct Money Substitutes

Legal tender currency, such as the U.S. dollar, has two defining characteristics: universal trade-ability for other goods and services, and its status as final payment for goods and services in the market.

Money directly chases all goods and services. Many money substitutes end up chasing money; their end goal is to be traded for dollars. For a money substitute to have a direct inflationary impact, it must ultimately be perfectly secure and immediately convertible at par value for standard currency.

This means that demand deposits and other checkable deposits can have direct inflationary impact. Other M2 substitutes fail one of the necessary criteria for direct money.

Money Supply Growth

From an economic perspective, money is a unique good, but it is a good nonetheless. Its supply and demand determines its trade value in the market. Prices rise when the supply of money grows too quickly – faster than productivity – because a situation arises where relatively more money chases relatively fewer goods.

The relationship is not one for one, however. Money must be economically active to affect prices. This means money must be used in economic transactions in such a way that nominal income is changed. If the Fed prints up a trillion dollars that never circulate, inflation does not occur.