Money is the lifeblood of the economy, and measuring it accurately is crucial. The money supply consists of different components, each with varying levels of . includes the most liquid forms like cash and checking accounts, while adds and other near-money assets.
Understanding how money is measured helps us grasp its role in the economy. As banking evolves with electronic payments and digital currencies, measuring money becomes more complex. These changes impact how we define and track the money supply, challenging central banks to adapt their policies and monitoring methods.
Measuring Money
Components of money supply
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M1 money supply
Physical cash in circulation includes coins and paper money
Readily available for immediate use in transactions
Funds held in checking accounts at banks and credit unions
Can be easily accessed and used for purchases or payments
Prepaid financial instruments used as an alternative to cash (American Express)
Can be replaced if lost or stolen, providing added security for travelers
M2 money supply
Encompasses all components of M1 (currency, checkable deposits, traveler's checks)
Savings deposits
Funds held in savings accounts at financial institutions
Typically earn interest but may have limitations on withdrawals (monthly limits)
(CDs) with balances less than $100,000
Require a minimum deposit amount and have a fixed maturity date (6-month CD)
Invest in short-term, low-risk securities such as government bonds
Offer check-writing privileges and higher interest rates than traditional savings accounts
assets
Highly liquid financial instruments that can be quickly converted to cash
Liquidity of money forms
Liquidity measures the ease and speed of converting an asset into cash without losing value
Hierarchy of liquidity (most to least liquid)
Currency (cash and coins)
Immediately available for use in transactions
Accepted as a medium of exchange by all sellers
Checkable deposits
Easily accessible through checks, , or online transfers
Funds can be quickly withdrawn or used for payments
Traveler's checks
Can be converted into cash at banks or used for purchases
Provide security and convenience for travelers
Savings deposits
Can be withdrawn from savings accounts, but may have some limitations
Funds are generally accessible within a short time frame (1-2 business days)
Small time deposits (CDs)
Require a fixed holding period before funds can be withdrawn without penalty
Less liquid than savings deposits due to time constraints
Money market mutual funds
Can be redeemed for cash, but may involve transaction costs or delays
Less liquid than other forms of money due to investment nature
Factors affecting liquidity
Accessibility
Ease of converting the asset into usable cash
Physical currency is the most accessible form of money
Stability of value
Likelihood of the asset maintaining its face value during conversion
Cash and checkable deposits have the most stable values
Transaction costs
Fees or penalties incurred when converting the asset into cash
Early withdrawal penalties on CDs reduce their liquidity
Banking changes and money measurement
Debit cards
Linked to checking accounts and allow for immediate fund transfers
Used for point-of-sale transactions and online purchases (Visa, Mastercard)
Extend short-term loans to consumers for purchases
Balances are repaid at a later date, often with interest charges
Facilitate peer-to-peer transactions and online payments (Venmo, Cash App)
May be linked to bank accounts or credit cards for funding
Impact on money measurement
Growing use of electronic payments reduces demand for physical currency
Electronic transactions may not be immediately captured in money supply data
Credit card balances are excluded from M1 and M2 until paid off
Faster transaction processing speeds up the circulation
Challenges for central banks
Updating money supply definitions to include emerging digital money forms
Monitoring and regulating the use of (Bitcoin, Ethereum)
Ensuring accurate and timely reporting of money supply data in a digital economy
Banking System and Money Creation
Consists of currency in circulation and bank reserves
Forms the foundation for money creation in the banking system
Banks keep only a fraction of deposits as reserves and lend out the rest
Enables banks to create money through the lending process
Banks act as intermediaries between savers and borrowers
Facilitates the efficient allocation of capital in the economy
Includes M2 and other less liquid financial assets
Provides a comprehensive measure of money supply in the economy
Key Terms to Review (22)
Broad Money: Broad money is a comprehensive measure of the total money supply within an economy, including not only currency in circulation but also various types of deposits and other liquid assets. It represents the total amount of money that can be readily accessed and used for transactions, investments, or other economic activities.
Certificates of Deposit: Certificates of deposit (CDs) are a type of savings account offered by banks and credit unions that typically pay a higher interest rate than a regular savings account in exchange for the customer agreeing to leave their money on deposit for a fixed period of time, known as the term or maturity date.
Checkable Deposits: Checkable deposits are a type of deposit account held at a financial institution, such as a bank, that allows the account holder to withdraw funds by writing a check or using a debit card. These deposits are considered part of the money supply and are a key component in measuring the money supply through metrics like M1 and M2.
Credit Cards: Credit cards are a type of revolving credit that allows individuals to make purchases and borrow money up to a predetermined limit, with the expectation of repaying the balance over time with interest. They are a crucial component in the measurement and understanding of the money supply as defined by M1 and M2 monetary aggregates.
Cryptocurrencies: Cryptocurrencies are digital or virtual currencies that use cryptography for security. They operate independently of a central bank or government and are based on blockchain technology, which allows for secure and transparent transactions.
Currency: Currency is a medium of exchange that is widely accepted as a form of payment for goods and services within an economy. It serves as a unit of account, a store of value, and a means of facilitating transactions between individuals and entities.
Debit Cards: Debit cards are a type of payment card that allows consumers to make purchases by directly accessing the funds in their checking or savings accounts. They function as an electronic substitute for cash, enabling users to make transactions without the need to carry physical currency.
Electronic Payment Systems: Electronic payment systems refer to the digital platforms and technologies that enable the transfer of funds between parties in financial transactions. These systems facilitate secure and efficient electronic payments, replacing traditional cash and check-based transactions.
Financial Intermediation: Financial intermediation is the process by which financial institutions, such as banks, act as intermediaries between those who have surplus funds (savers) and those who have a need for funds (borrowers). These institutions facilitate the flow of funds from savers to borrowers, thereby promoting economic growth and development.
Fractional Reserve Banking: Fractional reserve banking is a banking system where banks only hold a fraction of their total deposits as cash reserves, and use the remaining deposits to make loans. This allows banks to create money through the lending process, but also introduces the risk of bank runs and financial instability.
Liquidity: Liquidity refers to the ease and speed with which an asset can be converted into cash without losing its value. It is a measure of how quickly and easily an asset can be bought or sold in the market without significantly affecting its price. Liquidity is an important concept in the context of financial markets, money, banking, and international trade.
Liquidity Preference: Liquidity preference refers to an individual's or institution's desire to hold their wealth in the form of liquid assets, such as cash or cash equivalents, rather than less liquid assets like long-term investments. It is a key concept in Keynesian economics that helps explain the demand for money and the determination of interest rates.
M1: M1 is a measure of the money supply that includes the most liquid forms of money, such as cash, checking deposits, and travelers' checks. It represents the narrowest definition of the money supply and is considered the most important measure of the money available for immediate spending or transactions.
M2: M2 is a measure of the money supply that includes all the components of the narrower measure M1 (currency in circulation, traveler's checks, demand deposits, and other checkable deposits) plus savings deposits, small time deposits, and shares in retail money market mutual funds. M2 is a broader measure of the money supply compared to M1, as it includes more types of financial assets that can be readily converted into cash.
Mobile Payment Apps: Mobile payment apps are digital platforms that allow users to make transactions and payments using their smartphones or other mobile devices. These apps enable secure and convenient financial transactions, reducing the need for physical cash or cards.
Monetary Base: The monetary base, also known as the central bank money or high-powered money, refers to the total amount of currency and coin in circulation, plus the reserves held by commercial banks at the central bank. It is the fundamental building block of the money supply and plays a crucial role in the money creation process, monetary policy, and the overall functioning of the financial system.
Money Market Mutual Funds: Money market mutual funds are investment vehicles that pool together short-term, low-risk securities such as government bonds, commercial paper, and certificates of deposit. They provide investors with a safe and liquid way to earn a modest return on their cash holdings.
Near Money: Near money refers to assets that are highly liquid and can be quickly converted into cash, but are not considered legal tender or part of the money supply. These assets provide many of the same functions as money, such as serving as a medium of exchange and a store of value, but are not as easily spendable as currency.
Savings Deposits: Savings deposits are a type of bank account that allows individuals to deposit and store their money for future use. These accounts typically offer a modest interest rate and provide a safe place to save funds, with the primary purpose of accumulating wealth over time rather than facilitating day-to-day transactions.
Small Time Deposits: Small time deposits refer to short-term savings accounts or certificates of deposit (CDs) with relatively low balances, typically held by individual consumers or small businesses. These deposits are an important component of the money supply and are included in the M2 monetary aggregate.
Traveler's Checks: Traveler's checks are a type of prepaid payment instrument that can be used as an alternative to cash when traveling. They are issued by financial institutions and provide a secure way for travelers to access their funds while away from home, offering protection against theft or loss.
Velocity of Money: The velocity of money is a measure of the rate at which money circulates through the economy. It represents the average number of times a unit of currency is used to purchase goods and services within a given time period. This concept is closely tied to the functions of money and the measurement of the money supply.