M1 and M2 (Money Supply) - Explained
What is M1 and M2 Money Supply?
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What is the M1 and M2 Money Supply?
Economists offer broad definitions of money based on liquidity. Liquidity refers to how quickly you can use a financial asset to buy a good or service.
The Federal Reserve Bank, which is the central bank of the United States, is a bank regulator and is responsible for monetary policy and defines money according to its liquidity.
There are two definitions of money: M1 and M2 money supply.
What is the M1 Money Supply?
M1 money supply includes those monies that are very liquid such as cash, checkable (demand) deposits, and traveler’s checks.
M1 money supply includes coins and currency in circulation—the coins and bills that circulate in an economy that the U.S. Treasury does not hold at the Federal Reserve Bank, or in bank vaults.
Closely related to currency are checkable deposits, also known as demand deposits. These are the amounts held in checking accounts. They are called demand deposits or checkable deposits because the banking institution must give the deposit holder his money “on demand” when the customer writes a check or uses a debit card. These items together—currency, and checking accounts in banks—comprise the definition of money known as M1, which the Federal Reserve System measures daily.
What is the M2 Money Supply?
M2 money supply is less liquid in nature and includes M1 plus savings and time deposits, certificates of deposits, and money market funds.
A broader definition of money, M2 includes everything in M1 but also adds other types of deposits. For example, M2 includes savings deposits in banks, which are bank accounts on which you cannot write a check directly, but from which you can easily withdraw the money at an automatic teller machine or bank.
Many banks and other financial institutions also offer a chance to invest in money market funds, where they pool together the deposits of many individual investors and invest them in a safe way, such as short-term government bonds. Another ingredient of M2 are the relatively small (that is, less than about $100,000) certificates of deposit (CDs) or time deposits, which are accounts that the depositor has committed to leaving in the bank for a certain period of time, ranging from a few months to a few years, in exchange for a higher interest rate. In short, all these types of M2 are money that you can withdraw and spend, but which require a greater effort to do so than the items in M1.
M1 and M2 money have several definitions, ranging from narrow to broad. M1 = coins and currency in circulation + checkable (demand) deposit + traveler’s checks. M2 = M1 + savings deposits + money market funds + certificates of deposit + other time deposits.
The Federal Reserve System is responsible for tracking the amounts of M1 and M2 and prepares a weekly release of information about the money supply.
The lines separating M1 and M2 can become a little blurry. Sometimes businesses do not treat elements of M1 alike. For example, some businesses will not accept personal checks for large amounts, but will accept traveler’s checks or cash. Changes in banking practices and technology have made the savings accounts in M2 more similar to the checking accounts in M1.
For example, some savings accounts will allow depositors to write checks, use automatic teller machines, and pay bills over the internet, which has made it easier to access savings accounts. As with many other economic terms and statistics, the important point is to know the strengths and limitations of the various definitions of money, not to believe that such definitions are as clear-cut to economists as, say, the definition of nitrogen is to chemists.
What are Credit and Debit Cards?
Where does “plastic money” like debit cards, credit cards, and smart money fit into this picture? A debit card, like a check, is an instruction to the user’s bank to transfer money directly and immediately from your bank account to the seller. It is important to note that in our definition of money, it is checkable deposits that are money, not the paper check or the debit card. Although you can make a purchase with a credit card, the financial institution does not consider it money but rather a short term loan from the credit card company to you. When you make a credit card purchase, the credit card company immediately transfers money from its checking account to the seller, and at the end of the month, the credit card company sends you a bill for what you have charged that month. Until you pay the credit card bill, you have effectively borrowed money from the credit card company. With a smart card, you can store a certain value of money on the card and then use the card to make purchases. Some “smart cards” used for specific purposes, like long-distance phone calls or making purchases at a campus bookstore and cafeteria, are not really all that smart, because you can only use them for certain purchases or in certain places.
In short, credit cards, debit cards, and smart cards are different ways to move money when you make a purchase. However, having more credit cards or debit cards does not change the quantity of money in the economy, any more than printing more checks increases the amount of money in your checking account.
One key message underlying this discussion of M1 and M2 is that money in a modern economy is not just paper bills and coins. Instead, money is closely linked to bank accounts. The banking system largely conducts macroeconomic policies concerning money. The next section explains how banks function and how a nation’s banking system has the power to create money.
- Legal Tender
- Gresham's Law
- Functions of Money
- Gold Exchange Standard
- Bretton Woods System
- Fiat Money
- Monetary Base
- How Do Banks Create Money?
- Bank Balance Sheet
- Velocity of Money
- Multiplier Effect
- McCallum Rule
- Neutrality of Money
- Real Bills Theory
- Banking System?
- Central Bank
- Federal Reserve System
- Federal Open Market Committee (FOMC)
- Fed Balance Sheet
- Term Auction Facility
- Taylor Rule
- How is the Federal Reserve Bank Organized?
- What is Bank Regulation?
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- Federal Deposit Insurance Corporation
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- Central Banks Carry Out Monetary Policy
- Bank Reserve
- Discount Rate
- Federal Funds Rate
- Monetary Policy
- Contractionary and Expansionary Monetary Policy
- Easy Monetary Policy
- Accommodative Monetary Policy
- Dove & Hawk (Monetary Policy) - Explained
- Tight Monetary Policy - Explained
- Stabilization Policy
- Pushing on a String
- The Effect of Monetary Policy on Interest Rates
- Federal Funds Rate
- Gibson Paradox
- Vasicek Interest Rate Model
- Equation of Exchange (Economics)
- The Effect of Monetary Policy on Aggregate Demand
- Reserve Currency
- What are Excess Reserves?
- Unpredictable Movements of Velocity
- Central Banks - Unemployment and Inflation
- Fisher Effect
- Asset Bubbles and Leverage Cycles
- Quantity Theory of Money
- European Capital Market Institute