Measuring Money: Currency, M1, and M2
- Contrast M1 money supply and M2 money supply
- Classify monies as M1 money supply or M2 money supply
Economists offer broader definitions of money based on liquidity.
Liquidity refers to how quickly a financial asset can be used to buy a good or service.
- 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.
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.
- M1 money supply includes those monies that are very liquid such as cash (currency in circulation), checkable (demand) deposits, and traveler’s checks
- currency in circulation: the coins and bills that circulate in an economy that are not held by the U.S. Treasury, at the Federal Reserve Bank, or in bank vaults
- checkable deposits, also known as demand deposits: 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
- Traveler’s checks are also included in M1, but have decreased in use over the recent past
- M2 money supply is less liquid in nature. As a broader definition of money, M2 includes everything in M1 but also adds other types of deposits. 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
- 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 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
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.
"Plastic money" like credit cards and debit cards are different ways to move money when a purchase is made.
- 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, it is not considered money but rather a short term loan from the credit card company to you. When you make a purchase with a credit card, 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.