Question

Suppose you withdraw \(\$ 1,000\) from a money market mutual fund and deposit the funds in your bank checking account. Briefly explain how this action will affect \(\mathrm{M} 1\) and \(\mathrm{M} 2 .\)

Short answer

The action of withdrawing \$1,000 from a money market mutual fund and depositing it into a checking account will increase M1 by \$1,000, while M2 will remain unchanged.

Step-by-step solution

Understand the Definitions

Understand that M1 is the most liquid forms of money like cash and checking deposits, while M2 includes M1 plus less liquid forms of money like savings deposits and money market mutual funds.

Analyze the Change in M1

Analyze the change in M1. There's an increase in cash in a checking account by withdrawing from the money market fund. Therefore, M1 increases by \$1,000.

Analyze the Change in M2

Analyze the change in M2. An amount is moving from one component of M2 (money market mutual fund) to another component of M2 (checking account). Thus, there is no change in the total M2.

Key concepts

Understanding M1 and M2

When it comes to understanding the different types of money in the economy, 'M1 and M2' are terms you'll frequently encounter. Essentially, these are categories that help economists classify the money supply based on how liquid, or easily usable, the funds are.

M1 is the most liquid form of money and includes physical currency, coins, and checking deposits. Basically, these are forms of money you can readily use to make purchases or pay debts without any additional steps.

M2 includes all of M1 but also encompasses slightly less liquid forms of money, such as savings deposits, certificates of deposit (CDs), and money market mutual funds. These are still part of the money supply but require a conversion or notice before you can use them like cash.

When you switch funds from a money market mutual fund into a checking account, you're transforming money from one form to another within the M2 category, but you are directly increasing the M1 money supply, as checking deposits are a component of M1.

The Liquidity of Money

The 'liquidity of money' refers to how quickly and easily money can be used for transactions. High liquidity means you can readily spend or transfer the money, while low liquidity indicates that accessing the funds for immediate use may be a bit more complex or time-consuming.

Highly liquid assets, like those in M1, don't require any conversion to spend. Think of them as being 'ready to go'. On the other hand, assets that fall under M2 might take some time or effort to convert to cash or it might come with certain conditions, like penalties for early withdrawal from a CD, for example.

Maintaining a balance between liquid assets for everyday transactions and less liquid assets for longer-term savings or investments is essential for individual financial health. This balance allows you to be prepared for both immediate expenditures and future financial needs.

Money Market Mutual Funds

Moving money from 'money market mutual funds' to checking accounts is often a strategy used by individuals to increase their liquidity. Money market funds are a type of mutual fund that invests in highly liquid, short-term securities. They are considered a safer investment than stocks or corporate bonds, though they typically provide lower returns. The money is relatively liquid, you can withdraw it when needed, but it's not as liquid as the money in your checking account.

Such funds are included in the M2 money supply because, while they are relatively liquid and safe, they are not directly usable for transactions like the funds in your wallet or your checking account.

Bank Checking Accounts

Your 'bank checking account' is a workhorse of daily finance. It's where your liquid assets are kept for regular transactions, such as purchasing groceries or paying bills. When you deposit money into a checking account, that money becomes part of the M1 money supply. It's available for you to use immediately, directly, and without restrictions, which is why an increase in checking account balances directly increases M1.

They are extremely liquid and are a critical component in the workings of the modern financial system. By transferring funds from a money market mutual fund to a checking account, you enhance your purchasing power without changing the total amount of M2.