27.2 Measuring Money: Currency, M1, and M2

Measuring Money

Money isn't just the cash in your wallet. Economists track several categories of money, ranked by liquidity (how quickly and easily something converts to spendable cash). These categories help the Federal Reserve monitor the economy and make policy decisions.

The banking system also plays a direct role in expanding the money supply. Through fractional reserve banking, a single deposit can ripple outward into a much larger increase in total money, with the Fed guiding the process through its policy tools.

M1 vs. M2 Money Supply

M1 is the narrow measure of the money supply. It captures the most liquid forms of money, the stuff you can spend right now or almost immediately.

• Currency — coins and paper bills in circulation (not sitting in bank vaults)
• Demand deposits — standard checking accounts; you can withdraw funds on demand with no waiting period
• Other checkable deposits (OCDs) — accounts like negotiable order of withdrawal (NOW) accounts and automatic transfer service (ATS) accounts. These function similarly to checking accounts but may earn some interest or have slightly different rules.

M2 is the broader measure. It includes everything in M1 plus near-money assets that are less immediately spendable but still relatively easy to convert.

• Savings deposits — earn interest but come with some restrictions, such as limited transfers per month
• Small-denomination time deposits (under $100,000) — also called certificates of deposit (CDs). You agree to leave your money deposited for a set period in exchange for a fixed interest rate. Withdrawing early typically means paying a penalty.
• Money market mutual fund shares — pooled investments in short-term, low-risk securities. They tend to offer higher yields than a regular savings account, but they aren't insured the same way bank deposits are.
• Money market deposit accounts (MMDAs) — bank accounts that blend features of checking and savings. They offer limited check-writing ability and usually pay higher interest than a standard savings account.

Financial Instruments: M1 or M2?

Banking System Money Creation

Fractional Reserve Banking

Banks don't lock all your deposits in a vault. Under fractional reserve banking, they hold only a fraction of deposits as reserves (vault cash plus deposits at the Federal Reserve) and lend the rest out. Those loans eventually get deposited in other banks, which lend out a portion of those deposits, and so on. Each round of lending creates new money in the economy.

The Money Multiplier

This chain of lending and re-depositing means an initial deposit can expand the money supply well beyond its original amount. The theoretical maximum is captured by the money multiplier formula:

$\text{Money Multiplier} = \frac{1}{\text{Reserve Ratio}}$

Example with a 10% reserve ratio:

1. You deposit $1,000 in Bank A.
2. Bank A holds $100 (10%) as reserves and lends out $900.
3. That $900 gets deposited in Bank B, which holds $90 and lends out $810.
4. Bank C receives $810, holds $81, and lends out $729.
5. This process repeats through many rounds.

The multiplier is $\frac{1}{0.10} = 10$, so the original $1,000 deposit can generate up to $10,000 in total deposits across the banking system.

In practice, the actual expansion is usually smaller than the theoretical maximum. Banks sometimes hold excess reserves (more than required), and borrowers don't always re-deposit every dollar. Still, the multiplier captures the core mechanism.

The Federal Reserve's Policy Tools

The central bank (the Federal Reserve) influences how much money creation occurs through several tools:

• Reserve requirements — the percentage of deposits banks must hold as reserves. A higher requirement means less money available to lend, which shrinks the multiplier. A lower requirement does the opposite.
• Open market operations — the Fed buys or sells government securities (like Treasury bonds). Buying securities injects money into the banking system; selling them pulls money out. This is the Fed's most frequently used tool.
• Discount rate — the interest rate the Fed charges banks for short-term loans. A lower discount rate makes borrowing cheaper for banks, encouraging more lending. A higher rate discourages it.

Each of these tools changes how much money flows through the fractional reserve system, giving the Fed significant control over the overall money supply.