Question

For each of the following transactions, what is the initial effect (increase or decrease) on M1? On M2? a. You sell a few shares of stock and put the proceeds into your savings account. b. You sell a few shares of stock and put the proceeds into your checking account. c. You transfer money from your savings account to your checking account. d. You discover \(\$ 0.25\) under the floor mat in your car and deposit it in your checking account. e. You discover \(\$ 0.25\) under the floor mat in your car and deposit it in your savings account.

Short answer

Answer: Transferring money from a savings account to a checking account causes an increase in M1, as checking accounts are part of M1. There is no overall change in M2, as the total amount of money hasn't changed, just its allocation within M2 components.

Step-by-step solution

a. Selling stock and putting proceeds into savings account

Neither M1 nor M2 is affected by selling the stock, as stocks are not considered part of the money supply. However, when the proceeds are deposited into a savings account, it will cause an increase in M2 since savings accounts are part of M2 but not M1. So, there is no effect on M1 and an increase in M2.

b. Selling stock and putting proceeds into checking account

Selling the stock does not affect either M1 or M2. When the proceeds are deposited into a checking account, this will increase both M1 and M2, as checking accounts are part of M1, and by extension, part of M2.

c. Transferring money from savings account to checking account

When transferring money from a savings account to a checking account, you are moving money from one component of M2 to another. This will cause an increase in M1 since checking accounts are part of M1, and a decrease in the savings account component of M2. However, the overall amount of M2 remains unchanged as the total amount of money hasn't changed, just its allocation within M2 components.

d. Finding $0.25 and depositing it into checking account

When you discover \(0.25 and deposit it into your checking account, this will increase both M1 and M2. The physical currency is part of M1, and when it is deposited into a checking account, it remains in M1. Since M2 includes everything in M1, M2 will also increase by \)0.25.

e. Finding $0.25 and depositing it into savings account

Similar to part d, finding the $0.25 will not affect M1 or M2 until it is deposited. When it is deposited into a savings account, it will cause an increase in M2, as savings accounts are part of M2 but not M1. There is no effect on M1 and an increase in M2.

Key concepts

M1

M1 represents the narrowest measure of the money supply in an economy. It includes the most liquid and readily accessible forms of money, which means money that can be quickly used for transactions. The key components that make up M1 are:

• Physical currency in circulation, such as coins and paper money.
• Demand deposits, or funds in checking accounts.
• Other checkable deposits, such as traveler's checks.

When considering changes in M1, we look at activities like depositing cash into checking accounts. For example, if you find some money under your car mat and deposit it into your checking account, M1 increases because that physical currency is now also counted as part of the deposit in a checking account.

M2

M2 is a broader measure of the money supply compared to M1. It encompasses all of M1 and adds several other types of accounts that can be readily converted into cash or checking account balances. Components of M2 include:

• All the money in M1.
• Savings accounts, which although not directly accessible for shopping, can be quickly transferred to a checking account or converted to cash.
• Small time deposits, like certificates of deposit under $100,000.
• Retail money market mutual funds.

Transactions like transferring money from a savings account to a checking account don't change M2's total amount since it's simply a shift within its components. However, putting proceeds from a stock sale into a savings account increases M2 because savings are included in this measure, while M1 remains unaffected by stocks or savings movements.

Checking Account

A checking account is a type of deposit account held at a financial institution that allows for withdrawals, deposits, and other transactions like writing checks. It is highly liquid because it facilitates everyday spending and is part of M1 due to its immediate accessibility for transactions. Key characteristics include:

• Allows easy access to funds through checks and debit cards.
• Typically earns little or no interest.
• Often used for day-to-day transactions, bill payments, and managing business finances.

When money is deposited into a checking account, it immediately increases both M1 and M2 due to its inclusion in both measures of the money supply.

Savings Account

A savings account is a deposit account designed for accumulating funds and allows the account holder to earn interest on their balance over time. Although not as liquid as checking accounts, savings accounts serve as a secure place to store funds with some level of accessibility. Characteristics of savings accounts include:

• Higher interest rates compared to checking accounts.
• Limited transactions allowed per month.
• Acts as a buffer for emergency funds or savings plans.

While money in a savings account is part of M2, it is not included in M1. This means transactions involving savings accounts affect M2 calculations. For instance, depositing proceeds from a stock sale into a savings account increases M2, while keeping M1 unchanged, as it does not involve immediate payment transaction facilitation.