Question

"M2 is a better definition of the money supply than M1." Agree or disagree with this statement. In your argument, clearly state the criteria on which you are basing your decision.

Short answer

In conclusion, M2 is a better definition of the money supply than M1 because it encompasses a wider range of components relevant to economic functioning. While M1 focuses on the most liquid assets, M2 includes additional elements such as savings deposits, small time deposits, and non-institutional money market funds, providing a more complete representation of the economy's spending power. By choosing the criteria of consistency, relevant economic factors, and usefulness for policy decisions, it becomes clear that M2 is the superior definition. Although M1 offers ease of measurement, M2's broader scope grants policymakers more in-depth information that can better inform monetary policy decisions. However, it is important to note that the choice of a better definition depends on the chosen criteria, and other factors may lead to different conclusions. Additionally, considering both M1 and M2 can provide a more comprehensive understanding of the money supply and its implications on the economy.

Step-by-step solution

Define M1 and M2

Begin by defining M1 and M2 definitions of the money supply. M1 is the narrowest definition of the money supply, and includes currency in circulation, demand deposits, and other checkable deposits. M2 is a broader measure of money supply that includes all components of M1, as well as savings deposits, small time deposits, and non-institutional money market funds.

Choose the criteria for evaluation.

To assess the superiority of one definition over another, criteria such as the following could be used: 1. Consistency and ease of measurement – The definition should provide consistent measurements of the money supply over time, avoiding frequent revisions or changes in its components. 2. Relevant economic factors – The definition should include components that are most relevant to the overall functioning of the economy, such as liquidity and the influence on spending and investment. 3. Usefulness for policy decisions – The definition should be helpful for policymakers making decisions about monetary policy and interest rates.

Compare M1 and M2 based on the chosen criteria.

Evaluate both M1 and M2 based on the selected criteria to discover which definition is better suited for the chosen criteria. For example, 1. Consistency and ease of measurement – Both M1 and M2 provide consistent measurements, but M2 may be more difficult to measure since it includes components such as small time deposits, which can fluctuate frequently. 2. Relevant economic factors – M1 includes only the most liquid components, while M2 features other components that represent a larger share of the money supply. M2 may therefore provide a more complete picture of the economy's available spending power. 3. Usefulness for policy decisions – Both M1 and M2 are used by policymakers to assess the economy's health, but M2 may provide more in-depth information to guide monetary policy decisions due to its additional components.

Present your conclusion.

After evaluating M1 and M2 based on the chosen criteria, present your conclusion. For example, you can argue that M2 is a better definition of the money supply than M1 because it includes components with a broader impact on the economy, which makes it more useful for government policymakers. Remember to justify your decision based on the criteria you have chosen, and to acknowledge any limitations or caveats in your argument.

Key concepts

M1

M1 is the most basic or narrow measure of the money supply. It mainly includes:

• Currency in circulation, which is the cash composed of coins and notes used in daily transactions.
• Demand deposits, which are funds in checking accounts that can be withdrawn without any notice.
• Other checkable deposits that can be quickly converted to cash or used for writing checks.

In terms of liquidity, M1 is the most liquid form of money because it includes assets that can be readily transformed into goods and services. Its components are the primary means for payments and transactions in the economy. However, it's important to note that while M1 gives a clear picture of liquid assets, it may not capture all the economic activities, as it excludes broader forms of money.

M2

M2 expands on M1 by including additional forms of money. It encompasses:

• All components of M1, such as currency, demand deposits, and checkable deposits.
• Savings deposits, which are funds that earn interest but are not as easily accessible as checking accounts.
• Small time deposits, which are similar to fixed deposits that earn interest over a specific term.
• Non-institutional money market funds, which are investments that offer high liquidity with some features of savings accounts.

As a broader measure, M2 captures a larger spectrum of the economy's money supply. It includes near-money, which represents savings that can't be used directly for transactions but can be easily converted into cash. This measure gives a more comprehensive picture of the total money available in an economy, often used to forecast spending and policy impacts due to its inclusivity.

Monetary Policy

Monetary policy refers to the actions taken by central banks to control the money supply and interest rates within an economy. These policies are crucial for:

• Maintaining price stability by preventing excessive inflation or deflation.
• Ensuring low unemployment through measures that stimulate economic growth.
• Facilitating proper economic growth by adjusting interest rates and controlling the availability of money.

Policymakers use both M1 and M2 to gauge economic health, although M2, with its broader scope, provides more detailed insights. It allows for more nuanced adjustments because it reflects not only the money used for everyday transactions but also savings and investments. Properly executed monetary policies can influence economic activities significantly by affecting consumer and business expenditures.

Liquidity

Liquidity describes how quickly an asset can be converted into cash. This is a vital aspect of money because it determines how easily it can be used in transactions. For example:

• M1 components, like cash and demand deposits, are extremely liquid as they can be readily spent immediately.
• On the other hand, M2 includes less liquid assets, such as savings accounts, that require further steps before they can be spent.

Liquidity is essential for understanding how different components of the money supply impact the economy. Highly liquid money, like M1, facilitates immediate payments and transactions, while M2's less liquid forms signify potential future spending. This distinction becomes vital in determining how money supply measures affect economic behavior and policy decision-making.

Economic Measurement Criteria

Economic measurement criteria are essential for evaluating the effectiveness of different money supply definitions. They encompass several key factors:

• Consistency and ease of measurement, ensuring that these definitions remain stable over time.
• Relevance to economic conditions, making sure components reflect significant aspects of the economy.
• Usefulness for policymaking, where the measures aid in designing effective monetary policies.

When comparing M1 and M2, these criteria help establish which provides a better framework for understanding the economy. M1 offers simplicity and ease for transactions, while M2 provides a varied view, capturing money's potential uses. Policymakers look at these criteria to decide on appropriate strategies for economic control and growth, recognizing M2's broader scope can be particularly advantageous.