Money isn't just the cash in your wallet. It's a complex system of different types, from the most liquid forms to less accessible savings. Understanding how we measure and create money is key to grasping its role in the economy.

The banking system plays a crucial part in expanding the money supply. Through fractional reserve banking and the money multiplier effect, a small initial deposit can lead to a much larger increase in the overall money supply, with the central bank guiding the process.

Measuring Money

M1 vs M2 Money Supply

• M1 narrow measure of money supply includes most liquid forms of money
  • Currency coins and bills used for immediate transactions
  • Demand deposits checking accounts that can be withdrawn on demand
  • Other checkable deposits (OCDs) like negotiable order of withdrawal (NOW) accounts and automatic transfer service (ATS) accounts allow limited check-writing privileges
• M2 broader measure of money supply includes M1 plus less liquid forms
  • Savings deposits earn interest but have withdrawal restrictions (minimum balance, limited transfers per month)
  • Small-denomination time deposits (less than $100,000) require funds to be left for a specified period to earn a fixed interest rate (certificates of deposit)
  • Money market mutual fund shares are investments in short-term, low-risk securities that offer higher yields than traditional savings accounts
  • Money market deposit accounts (MMDAs) combine features of checking and savings accounts, offering limited check-writing and higher interest rates than regular savings accounts

Financial Instruments M1 or M2

• M1 components currency, demand deposits, OCDs (NOW accounts, ATS accounts)
• M2 components include M1 plus savings deposits, small-denomination time deposits (less than $100,000), money market mutual fund shares, MMDAs

Banking System Money Creation

• Fractional reserve banking system banks hold fraction of deposits as reserves (vault cash, deposits at Federal Reserve), remaining deposits loaned out creating new money in economy
• Money multiplier effect initial deposit leads to chain of loans and deposits, increasing money supply beyond initial deposit
  • Formula: $\frac{1}{reserve_ratio}$ (10% reserve ratio, money multiplier is $\frac{1}{0.1} = 10$)
  • $1,000 initial deposit with 10% reserve ratio can create up to $10,000 in total deposits
• Central bank (Federal Reserve) impacts money supply through monetary policy tools
  • Sets reserve requirements percentage of deposits banks must hold in reserves
  • Open market operations buying and selling government securities to influence money supply and interest rates
  • Discount rate interest rate charged to banks for short-term loans from the Federal Reserve
  • Changing reserve requirements alters amount of money banks can lend out, affecting money creation process