Question

What is the main difference between the \(\mathrm{M} 1\) and \(\mathrm{M} 2\) definitions of the money supply? Why does the Federal Reserve use two definitions of the money supply rather than one?

Short answer

The primary difference between M1 and M2 lies in the liquidity of the assets they include; M1 only covers highly liquid forms while M2 extends to less liquid assets. The Federal Reserve uses both definitions to adjust their monetary policies based on the liquidity of money and to understand the overall economic trend.

Step-by-step solution

Define M1

M1 is a narrow measure of the money supply that includes only the most liquid forms of money; it includes currency, demand deposits, and other current accounts that can be easily converted to cash.

Define M2

M2 is a broader measure that includes everything in M1, as well as less liquid types of money. Specifically, M2 includes savings deposits, money market mutual funds and other time deposits, which are less liquid than M1 assets but can be converted into cash relatively easily.

Explain why the Federal Reserve uses two definitions

The Federal Reserve uses M1 when it wants to target short-term interest rates and control inflation, as it is a more liquid form of money and can circulate quickly. On the other hand, M2 is used when the Federal Reserve wants a broader perspective on the money supply to understand the overall trends in the economy.

Key concepts

M1

M1 is one of the two main categories used to define the money supply. Think of it as the money that's most readily available for making purchases. M1 includes the most liquid forms of money, such as:

• Currency in circulation (like coins and paper money)
• Demand deposits (these are checking accounts that allow quick access to funds)
• Other checkable deposits (like certain types of NOW accounts and share drafts)

These components are considered the core "cash" holdings of an economy because they can be converted into physical cash quickly and without much hassle.
Due to its liquidity, M1 plays a big role in everyday consumer and business transactions, making it crucial for the Federal Reserve to monitor when managing short-term interest rates. It reflects how much money is immediately available to fuel economic activities.

M2

M2 offers a more comprehensive view of the money supply than M1, as it includes everything within M1 and adds several other elements. These additional components are slightly less liquid but still hold significant value for understanding economic health. M2 encompasses:

• Savings deposits, which are not as liquid as checking accounts but can be accessed when needed
• Money market deposit accounts and mutual funds, which allow some liquidity while offering interest returns
• Time deposits, like certificates of deposit (CDs), which have fixed terms and typically offer higher returns than standard savings accounts

By observing M2, the Federal Reserve can gain insights into the overall financial stability and savings behaviors of the population.
M2 is often used to gauge broader economic trends, informing the Federal Reserve's decisions that affect long-term interest rates and economic policy.

Federal Reserve

The Federal Reserve, often referred to as "the Fed," is the central authority responsible for the monetary policy of the United States. Its main objectives are controlling inflation, maximizing employment, and ensuring the stability of the financial system.
To achieve these goals, the Fed employs two primary measures of the money supply: M1 and M2. Each serves different purposes:

• M1 is used to track liquidity in the economy, helping the Fed respond to immediate needs for cash and short-term financial changes.
• M2 provides a broader economic viewpoint, useful for assessing long-term economic trends and savings habits.

By leveraging both M1 and M2, the Federal Reserve can craft monetary policies that support economic growth while managing inflation and stabilizing the currency. This dual approach allows the Fed to address both immediate financial concerns and longer-term economic challenges.