Question

Suppose you decide to withdraw \(\$ 100\) in currency from your checking account. What is the effect on M1? Ignore any actions the bank may take as a result of your having withdrawn the \(\$ 100 .\)

Short answer

Withdrawing $100 in currency from the checking account does not change the total M1 money supply. The form of money changes from checkable deposits to currency, but the total amount remains the same.

Step-by-step solution

Understand M1

M1 is a measure of the money supply that includes physical currency, demand deposits, traveler's checks, and other checkable deposits. In simpler terms, M1 is the money available for spending immediately.

Analyze the Effect of Withdrawal

You are withdrawing $100 from your checking account. Therefore, the amount of money in your checking account decreases by $100.

Determine the Change in M1

Since M1 includes both physical currency and money in checkable deposits (including your checking account), simply withdrawing money from the checking account and holding it as cash doesn't change the total supply of M1. The money is just changing from one form (checkable deposit) to another form (currency).

Key concepts

Money Supply and the Economy

Understanding the concept of money supply is crucial for grasping how economies function. The money supply, particularly M1, represents the most liquid forms of money available in an economy. It includes physical currency — the notes and coins that are in circulation; checkable deposits — which are bank accounts that allow you to write checks or use a debit card; and other highly liquid instruments.

When the money supply increases, consumers and businesses generally have more funds available to spend and invest, which can stimulate economic activity. Conversely, a decrease in the money supply can slow down the economy, as there is less money available for purchasing goods and services. It's important to remember that movements in M1 are not just numerical changes; they signify shifts in an economy's lifeblood — the immediate spending power of consumers and businesses alike.

When analyzing a seemingly simple action like withdrawing cash from a checking account, the overall money supply, in this case M1, remains unchanged because the total amount of liquid funds doesn't decrease — it just shifts from one form (checkable deposits) to another (physical currency). What's essential is how these forms of money interact with the broader economy, influencing everything from inflation rates to interest rates and overall economic growth.

Checkable Deposits

Checkable deposits play a pivotal role in the M1 money supply, as they constitute the portion of the money that individuals and companies can quickly access for daily transactions. These deposits remain in accounts that allow for the writing of checks or the use of debit cards. They are considered highly liquid because they can be easily and swiftly converted into physical currency or used directly for electronic transactions.

Understanding the nature of checkable deposits is fundamental when considering personal financial decisions and their broader economic implications. For example, when a person withdraws money from a checkable deposit, such as a checking account, they are not reducing the total money supply — they are merely converting their money from one form of M1 to another. This action reflects an individual's preference for cash over deposits but does not impact the overall level of money available in the economy for immediate spending.

In the step-by-step solution presented in the educational exercise, the action of withdrawing cash from a checking account highlights the direct swap within the forms of M1 without affecting the macroeconomic perspective of the total money supply.

Physical Currency

Physical currency, comprising coins and paper money, is the most recognizable and tangible form of money. It represents one part of the M1 money supply and is critical for everyday transactions. Physical currency is favored for its immediacy and universal acceptance in face-to-face transactions. It's often seen in the hands of consumers as they pay for goods and services, and it moves quickly from person to business and back again.

Despite the rise of digital payments, physical currency retains a significant place in the economy. It is especially crucial for sectors where electronic transactions are less common or for certain groups of people who may not have access to banking services. When analyzing the M1 money supply, physical currency is essential because it facilitates direct and immediate commerce without the intermediary of a financial institution.

However, the choice to hold money in the form of physical currency does not alter the fact that it is still part of the M1 money supply. Whether it is stored in a wallet or a checking account, its value to the economy remains the same. The educational exercise of a cash withdrawal perfectly illustrates this concept, where the individual's holdings of M1 convert forms but the total supply of money ready for transactions in the economy does not decrease.