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 narrowest commonly used measure of the money supply. Under the Federal Reserve's current definition, it captures the most liquid money and bank deposits.
- 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.
- Other liquid deposits, including savings deposits — since the Fed's May 2020 update, savings deposits are included in M1 because they are liquid bank deposits, even though they are not usually used directly at the point of sale.
M2 is the broader measure. It includes everything in M1 plus other near-money assets that are less immediately spendable but still relatively easy to convert.
- 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.
- Retail money market mutual fund shares — pooled investments in short-term, low-risk securities. Redeeming shares can involve processing time or transaction costs.
Current Fed definition: M1 includes savings deposits; M2 = M1 + small time deposits + retail money market mutual funds. Some older textbooks and practice materials use the pre-May-2020 convention where savings deposits were in M2 but not M1, so always read the question's definitions carefully.
Financial Instruments: M1 or M2?
| Category | Components |
|---|---|
| M1 | Currency, demand deposits, OCDs (NOW accounts, ATS accounts) |
| M2 | Everything in M1 plus savings deposits, small-denomination time deposits (CDs under $100,000), money market mutual fund shares, MMDAs |
The key distinction is liquidity. If you can write a check on it or spend it directly, it's M1. If you need to transfer it, wait for a maturity date, or sell shares first, it falls into the broader M2 category.
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:
Example with a 10% reserve ratio:
- You deposit $1,000 in Bank A.
- Bank A holds $100 (10%) as reserves and lends out $900.
- That $900 gets deposited in Bank B, which holds $90 and lends out $810.
- Bank C receives $810, holds $81, and lends out $729.
- This process repeats through many rounds.
The multiplier is , 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.