Question

Two definitions of money supply are \(\mathrm{M}_{1}\) and \(\mathrm{M}_{2}\). Differentiate between the two.

Short answer

M1 money supply includes the most liquid forms of money, such as physical currency and checkable deposits like checking accounts, demand deposits, and negotiable order of withdrawal (NOW) accounts. M2 money supply is a broader measure that includes everything in M1 and some less liquid financial instruments such as savings deposits, certificates of deposit (less than $100,000), and money market funds. The main difference between M1 and M2 is that M1 focuses on the most liquid assets, while M2 includes both liquid and "near money" assets that can be easily converted into cash or checkable deposits.

Step-by-step solution

Define M1 money supply

M1 money supply is a measure of the total amount of money in circulation within an economy, specifically the most liquid forms of money. It includes physical currency (coins and notes) and checkable deposits like checking accounts, demand deposits, and negotiable order of withdrawal (NOW) accounts.

Define M2 money supply

M2 money supply is a broader measure of money supply than M1. In addition to including everything in M1, M2 also includes less liquid financial instruments such as savings deposits, certificates of deposit (less than $100,000), and money market funds.

Highlight the differences between M1 and M2 money supplies

The main difference between M1 and M2 money supplies is that M1 only includes the most liquid forms of money, such as physical currency and checkable deposits. On the other hand, M2 is a broader measure that includes both the liquid assets from M1 and some less liquid financial instruments like savings deposits and money market funds. The less liquid components of M2 are considered "near money" because they can be easily converted into cash or checkable deposits.

Key concepts

M1 money supply

The M1 money supply is often considered the narrowest definition of money supply within an economy. It emphasizes the most liquid forms of money, which means money that can be spent immediately, such as cash. M1 includes:

• Physical currency: These are the coins and banknotes that people use for daily transactions.
• Checkable deposits: These include funds available in checking accounts which can be accessed using checks or debit cards.
• Demand deposits: These are accounts from which money can be withdrawn without prior notice.
• Negotiable Order of Withdrawal (NOW) accounts: These are interest-earning bank accounts that allow the owner to write drafts against the balance.

These components make M1 the most straightforward and liquid form of money in the money supply spectrum.

M2 money supply

M2 money supply expands upon M1 by including all the components of M1, plus additional types of accounts that are slightly less liquid. This makes M2 a more comprehensive measure of the money supply, reflecting both readily accessible funds and those that can be converted to cash relatively easily. M2 includes:

• All components of M1: So, it incorporates physical currency, checkable deposits, etc.
• Savings deposits: These are accounts that earn interest and typically require notice before withdrawal, but are still easily accessible.
• Certificates of Deposit (CDs): Specifically those under $100,000, which are time deposits that restrict access to funds until maturity.
• Money Market Funds: These are mutual funds that invest in low-risk, short-term securities and allow limited checks to be written.

While M1 represents the most liquid assets, M2 includes these additional account types, which are termed "near money." Though less liquid than M1 components, they can still be converted into cash in a relatively short timeframe.

Liquidity

Liquidity refers to how quickly and easily an asset or financial instrument can be converted into cash, or used directly to purchase goods and services, without affecting its value. Different assets and account types have varying levels of liquidity:

• M1 components are the most liquid, as they consist of money that can be spent immediately.
• M2 components are less liquid but still accessible in a short time frame, such as savings accounts or small CDs.

High liquidity means assets can be readily traded or sold, while low liquidity indicates that more time and effort are required to convert assets to cash.
The concept of liquidity is crucial for understanding the money supply, as it determines how different types of money can be used in the marketplace. Liquid assets enable consumers and businesses to meet immediate funding needs, whereas less liquid assets may require planning and time to access.

Financial instruments

Financial instruments are contracts that represent an asset to one party and a liability to another. They are essential in the financial world to facilitate the transfer, allocation, and management of capital. Common financial instruments include:

• Currency: The most basic and universally accepted financial instrument.
• Deposits: Including checking, savings, and fixed deposits, these involve agreements between banks and consumers over the access and use of funds.
• Bonds: Debt securities issued to raise capital, promising periodic interest payments and the return of principal at maturity.
• Money Market Instruments: Short-term debt instruments such as treasury bills, often used as safe places to park excess funds for a brief period.

Understanding financial instruments is crucial because they contribute to defining measures of money supply like M2. For instance, savings accounts and CDs, both part of M2, are considered financial instruments. They impact the liquidity available in the economy and reflect how individuals and businesses can move and utilize their funds efficiently.