Question

Which statement is true? (LO3) a) Credit cards are a form of money. b) Debit cards are a form of money. c) M2 is about six times the size of M1. d) \(\mathrm{M} 1\) is about six times the size of \(\mathrm{M} 2\).

Short answer

The correct answer is: c) M2 is about six times the size of M1.

Step-by-step solution

Understand the concepts

To solve this exercise correctly, we need to understand the meaning of the terms used in the statements provided: - Credit card: a small plastic card issued by a bank or financial institution that allows the cardholder to purchase goods or services on credit. - Debit card: a small plastic card issued by a bank or financial institution that allows the cardholder to pay for goods or services instantly by automatically deducting the amount from the user's bank account. - M1: a measure of the money supply that includes currency (coins and notes) in circulation and demand deposits such as checking accounts. - M2: a measure of the money supply that includes M1 as well as some less liquid forms of money such as savings deposits, small time deposits, and some money market funds.

Evaluate the statements

Now let's evaluate each statement based on these definitions: a) Credit cards are a form of money: This statement is false because credit cards are not a store of value in and of themselves, but rather a method for accessing borrowed funds to make purchases. b) Debit cards are a form of money: This statement is also false because debit cards are not a store of value but a method for accessing funds from the user's bank account, which can be considered money in the form of demand deposits (part of M1). c) M2 is about six times the size of M1: In general, M2 is larger than M1 because it includes all the components of M1 plus additional less liquid financial assets. However, the exact ratio of M2 to M1 can vary depending on the country and time. We don't have specific numbers here to confirm this statement, but it is possible that M2 is about six times the size of M1. d) M1 is about six times the size of M2: This statement is false because it contradicts the definition stated earlier, which mentioned that M2 is a broader measure of the money supply than M1, meaning M2 should be larger than M1.

Choose the correct answer

Since we have evaluated each statement, we can conclude that the answer is: c) M2 is about six times the size of M1.

Key concepts

Credit Cards

Understanding credit cards is crucial when dealing with concepts of the money supply. A credit card is not money, but a payment tool that offers access to a line of credit extended by a financial institution. Upon using a credit card to make a purchase, you're essentially borrowing money from the card issuer up to a certain limit, with the obligation to pay back the borrowed amount, often with interest, at a later date.

Importantly, credit cards facilitate consumer spending by allowing users to make purchases they may not have the immediate funds for. Although they play a vital role in the economy, they do not represent a store of value like cash or deposits, and hence are not considered part of the money supply.

Impact on Economy

Credit cards can have a significant impact on the economy by enabling higher consumer expenditure which, in turn, can stimulate economic activity. However, they can also lead to increased consumer debt if not managed responsibly.

Debit Cards

Debit cards are often mistaken for their plastic counterpart, the credit card. Unlike credit cards, debit cards grant access to your own funds in a checking account, often referred to as demand deposits. When you use a debit card, the money is immediately transferred from your account to the merchant's account. It's crucial to note that while debit cards are not money, the funds they access are part of the money supply.

Specifically, because the funds from debit card transactions come directly from demand deposits, they fall within the definition of M1, which is the most liquid portion of the money supply.

Convenience and Budgeting

Debit cards confer convenience, reducing the need to carry cash and helping in better budgeting since they can prevent spending more money than what is available in the account.

M1 and M2

The categorizations of M1 and M2 are central to understanding money supply. M1 refers to the most liquid forms of money, including physical currency in circulation and demand deposits like checking accounts. It is money that can be easily used for transactions.

On the other hand, M2 includes everything in M1, plus near-money assets that are less liquid, such as savings accounts, small time deposits (like certificates of deposit under $100,000), and non-institutional money market funds. While these forms of money are not as readily accessible for transactions as those in M1, they can be converted into liquid funds with relative ease. Consequently, M2 is a broader measure of the economy's money supply.

Relevance for Monetary Policy

Monetary authorities scrutinize both M1 and M2 when setting economic policies, as changes in these aggregates can reflect or influence the economic conditions. For instance, rapid growth in M1 or M2 could signal inflationary pressures, prompting central banks to adjust interest rates.

Demand Deposits

Demand deposits are a fundamental component of M1, representing money stored in bank accounts from which funds can be withdrawn at any time without any advance notice or penalty. They include checking accounts and are often accessible via checks, ATMs, and electronic transfers, including the use of debit cards.

Note that while savings accounts are also deposits, they typically have some limitations on access or number of withdrawals and thus fall under M2 rather than M1. Demand deposits are highly significant for day-to-day transactions as they represent liquid assets readily available for usage.

Role in Money Creation

Banks use demand deposits to extend loans, which is a cornerstone process in money creation. This banking function underscores the pivotal role of demand deposits not only in individuals' liquidity but also in the overall functioning of a modern economy's financial system.