178 Measuring Money: Currency, M1, and M2
Learning Objectives
- Contrast and classify monies as either M1 money supply and M2 money supply
Measuring Money: Currency, M1, and M2
We defined money as anything that is generally accepted as a means of payment, is a store of value, can be used as a unit of account or a standard of deferred payment. What exactly is included?
Cash in your pocket certainly serves as money. But what about checks or credit cards? Are they money, too? Rather than trying to state a single way of measuring money, economists offer broader definitions of money based on the concept of liquidity. Liquidity refers to how quickly an asset can be used to buy a good or service. Liquidity is a relative concept. For example, cash is very liquid. Your $10 bill can be easily used to buy a hamburger at lunchtime. However, $10 that you have in your savings account is not so easy to use. You must go to the bank or ATM machine and withdraw that cash to buy your lunch. Thus, $10 in your savings account is less liquid. Stocks and bonds are even less liquid, since they must be sold to convert them to means of payment, and they might suffer a loss in value in the process.
Economists generally use two definitions of the supply of money: M1 and M2. M1 includes those assets that are the most liquid such as cash, checkable (demand) deposits, and traveler’s checks. M2 includes M1 plus some less liquid (but still fairly liquid) assets, including savings and time deposits, certificates of deposit, and money market funds. Let’s examine these two money definitions in more detail.
M1
M1 is the most narrow definition of the money supply. It includes coins and currency in circulation—in other words they are not held held by the U.S. Treasury, or the Federal Reserve Bank, but circulate in the economy.
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 a check is written or a debit card is used. These items together—currency, and checking accounts in banks—make up most of M1. Traveler’s checks are also included in M1, but have decreased in use over the recent past.
M2
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 the deposits of many individual investors are pooled together and invested in a safe way, such as short-term government bonds. Another ingredient of M2 is small denomination (that is, less than about $100,000) certificates of deposit (CDs) or time deposits, which are account