14.2 Measuring Money: Currency, M1, and M2

Measuring Money

Money supply measurement matters because the Federal Reserve uses these numbers to make policy decisions that affect interest rates, inflation, and employment. Different "buckets" of money exist based on how quickly you can spend them.

Components of the Money Supply

The money supply is split into two main categories: M1 and M2. The key difference is liquidity, which means how easily and quickly something can be used as cash.

M1: The Most Liquid Money

M1 captures money you can spend right now, without converting or waiting:

• Currency — Physical coins and paper money circulating in the economy. This is the most straightforward form of money: you hand it over, and the transaction is done.
• Checkable deposits — Funds in checking accounts at banks and credit unions. You access these through checks, debit cards, or online transfers. They function almost identically to cash for everyday purchases.
• Traveler's checks — Prepaid instruments (like those from American Express) that work as a cash substitute. They can be replaced if lost or stolen. These are a tiny and shrinking part of M1 today.

M2: M1 Plus Near-Money Assets

M2 includes everything in M1, plus assets that are close to cash but take a small extra step to spend:

• Savings deposits — Funds in savings accounts that typically earn interest. You can withdraw them, but there may be limits on how often (for example, some accounts historically capped certain transfers at six per month).
• Small time deposits — Certificates of deposit (CDs) with balances under $100,000. You deposit money for a fixed period (say, 6 months or 2 years) and earn a set interest rate. Withdrawing early usually triggers a penalty.
• Money market mutual funds — Funds that invest in short-term, low-risk securities like government bonds. They often offer check-writing privileges and slightly higher interest rates than regular savings accounts, but redeeming shares can involve small delays or costs.

Liquidity of Money Forms

Liquidity measures how easily and quickly you can convert an asset into spendable cash without losing value. Here's the hierarchy from most to least liquid:

1. Currency — Immediately spendable. Every seller accepts it.
2. Checkable deposits — Nearly as liquid as cash. A debit card swipe or online transfer moves these funds in seconds.
3. Traveler's checks — Spendable at many locations or convertible to cash at banks, but less universally accepted than currency.
4. Savings deposits — Accessible within a day or two, but you typically can't pay for groceries directly from a savings account.
5. Small time deposits (CDs) — Locked up until the maturity date. Withdrawing early means paying a penalty, which effectively reduces their value.
6. Money market mutual funds — Redeemable for cash, but redemption may involve processing time or transaction costs.

Three factors determine where an asset falls on this spectrum:

• Accessibility — How quickly can you get the money into a spendable form?
• Stability of value — Will the asset hold its face value when you convert it? Cash and checking deposits are the most stable. A CD cashed out early loses some value to penalties.
• Transaction costs — Are there fees or penalties for converting? Early withdrawal penalties on CDs and redemption fees on some funds reduce liquidity.

Banking Changes and Money Measurement

The rise of electronic payments has changed how people use money, which complicates how we measure it.

Electronic Payment Systems

• Debit cards link directly to checking accounts and transfer funds immediately at the point of sale. The money involved is already counted in M1 as checkable deposits.
• Credit cards extend short-term loans for purchases. Balances are repaid later, often with interest. Credit card spending is not counted in M1 or M2 because it represents borrowed money, not money you already have.
• Mobile payment apps (Venmo, Cash App, Zelle) facilitate quick transfers between people. These are typically linked to bank accounts or cards, so the underlying funds are already captured in M1 or M2.

Impact on Money Measurement

Growing electronic payment use means less physical currency is needed for daily transactions, but the total money supply doesn't necessarily shrink; it just shifts form. Faster transaction processing also increases the velocity of money, meaning each dollar changes hands more quickly.

Challenges for Central Banks

• Defining which new digital instruments belong in M1 versus M2 (or neither)
• Monitoring cryptocurrencies like Bitcoin and Ethereum, which don't fit neatly into traditional money supply categories
• Ensuring money supply data stays accurate and timely as transactions become increasingly digital

Banking System and Money Creation

Banks don't just store money; they actively create it through lending.

• Monetary base — The starting point for money creation. It consists of currency in circulation plus reserves that banks hold at the Federal Reserve. Think of it as the "raw material" from which the broader money supply is built.
• Fractional reserve banking — Banks are required to keep only a fraction of deposits as reserves. The rest gets lent out. When that loaned money is deposited at another bank, that bank lends out a fraction of that, and the cycle continues. This process multiplies the original deposit into a larger total money supply.
• Financial intermediation — Banks channel funds from savers (who deposit money) to borrowers (who need loans). This matching process helps capital flow to where it's most productive in the economy.
• Broad money — A term for the widest measures of money supply, which include M2 and potentially other less liquid financial assets. It gives the most comprehensive picture of total money in the economy.