Question

Explain why you think the Federal Reserve Bank tracks M1 and M2.

Short answer

The Federal Reserve Bank tracks M1 and M2 to understand the dynamics of the money supply, inform monetary policy decisions, and evaluate the effectiveness of these policies in achieving price stability and promoting economic growth. M1 provides information about the most liquid forms of money which are directly used in transactions, while M2 offers a broader perspective on the availability of credit and overall liquidity in the financial system. Monitoring both monetary aggregates allows the Federal Reserve to assess the velocity of money, potential inflationary pressures, and changes in households' savings behavior, ultimately guiding its course of action towards desirable macroeconomic outcomes.

Step-by-step solution

Definition of M1 and M2

M1 and M2 are measures of the money supply in an economy. M1 includes the most liquid forms of money, including currency held by the public, checking deposits, and travelers' checks. M2 is the broader measure of the money supply, which includes M1 and adds savings deposits, small time deposits, and other short-term, near-money financial instruments.

Function of Money

Money has three main functions: 1) medium of exchange, used to buy and sell goods and services, 2) unit of account, which provides a common measure of value, and 3) store of value, which allows people to save purchasing power for future use. M1 is more focused on the medium of exchange function, while M2 also includes financial instruments that serve as the store of value.

Federal Reserve and Monetary Policy

The Federal Reserve, as the central bank of the United States, is responsible for conducting monetary policy. The primary goal of monetary policy is to maintain price stability and promote economic growth. The Federal Reserve influences the money supply and interest rates to achieve these goals. By tracking M1 and M2, the Federal Reserve can monitor fluctuations in the money supply and adjust its policy accordingly.

Importance of Monitoring M1 and M2

Monitoring M1 gives the Federal Reserve information about the most liquid forms of money, which can be used directly in transactions. This is important for assessing the velocity of money and the potential impact of changes in the money supply on inflation. Monitoring M2 gives the Federal Reserve a broader perspective on the availability of credit and the overall liquidity in the financial system. M2 includes financial assets that can be easily converted into M1, which makes M2 a useful indicator of potential future increases in M1. M2 can also provide insights into households' savings behavior and help inform policy decisions related to aggregate demand, inflation, and financial stability.

Evaluating Monetary Policy

By tracking M1 and M2, the Federal Reserve can assess the effectiveness of its monetary policy actions. For example, if the central bank wants to stimulate the economy, it may implement policies that increase the money supply. Increases in M1 and M2 can signal that the policy is having the desired effect. Conversely, if there is rapid growth in M1 or M2 without corresponding economic growth, it may indicate that inflationary pressures are building up, requiring corrective policy actions. In conclusion, the Federal Reserve Bank tracks M1 and M2 to understand the dynamics of the money supply, inform monetary policy decisions, and evaluate the effectiveness of these policies in achieving price stability and promoting economic growth. Monitoring both monetary aggregates provides the central bank with valuable information on the liquidity and credit conditions in the economy and helps guide its course of action towards desirable macroeconomic outcomes.