Defining the Money Supply: M1 and M2: Videos & Practice Problems

M1 and M2 are two classifications of the money supply distinguished by liquidity, which refers to how quickly assets can be converted into cash. M1 includes the most liquid forms of money such as currency (cash), demand deposits (like checking accounts), and savings accounts that can be accessed quickly. M2 includes everything in M1 plus less liquid assets like money market funds and certificates of deposit (CDs), which may require waiting periods to convert into cash. Essentially, M1 is a subset of M2, focusing on money that is readily available for spending, while M2 captures a broader range of money including near-money assets that are slightly less accessible.

Savings accounts were traditionally classified under M2 because they were considered less liquid than checking accounts. However, with advancements in online banking and ATM access, savings accounts have become much easier and quicker to access, making them more liquid. This increased liquidity means savings accounts now behave more like demand deposits, allowing quick transfers and withdrawals. As a result, modern classifications have moved savings accounts from M2 to M1 to better reflect their liquidity and role in the money supply. This change highlights how technology can influence monetary aggregates and the measurement of money in the economy.

Liquidity measures how quickly and easily an asset can be converted into cash for spending. In the context of money supply, M1 includes highly liquid assets such as currency, demand deposits, and savings accounts that can be accessed immediately or within a very short time. M2 includes all of M1 plus less liquid assets like money market funds and certificates of deposit, which may require waiting periods or penalties to convert into cash. The classification into M1 and M2 helps economists understand the availability of money for transactions versus savings or investments, which is crucial for analyzing monetary policy and economic activity.

Money market funds are investment funds that invest in short-term debt securities and offer relatively stable value but are less liquid than cash or checking accounts because converting them to cash can take a few days. Certificates of deposit (CDs) are time deposits with banks that have fixed maturity dates, meaning the money is locked in for a set period before withdrawal without penalty. Both are included in M2 because they represent money that is not immediately spendable but can be converted into cash or checking deposits with some delay. Including these assets in M2 provides a broader measure of the money supply, capturing near-money assets that influence economic activity.

Understanding M1 and M2 is essential for macroeconomic stabilization because these measures reflect the amount of money available for spending and saving in the economy. M1 shows the money readily available for transactions, which directly affects consumer spending and demand. M2 includes M1 plus near-money assets, indicating the total money that can influence economic activity when converted. Central banks monitor these aggregates to design monetary policies, such as adjusting interest rates or controlling money supply growth, to manage inflation, unemployment, and economic growth. Accurate knowledge of M1 and M2 helps policymakers predict how changes in money supply impact the broader economy.