Money is the lifeblood of the economy, and measuring it accurately is crucial. The money supply consists of different components, each with varying levels of liquidity. M1 includes the most liquid forms like cash and checking accounts, while M2 adds savings deposits and other near-money assets.

Understanding how money is measured helps us grasp its role in the economy. As banking evolves with electronic payments and digital currencies, measuring money becomes more complex. These changes impact how we define and track the money supply, challenging central banks to adapt their policies and monitoring methods.

Measuring Money

Components of money supply

• M1 money supply
  • Currency
    • Physical cash in circulation includes coins and paper money
    • Readily available for immediate use in transactions
  • Checkable deposits
    • Funds held in checking accounts at banks and credit unions
    • Can be easily accessed and used for purchases or payments
  • Traveler's checks
    • Prepaid financial instruments used as an alternative to cash (American Express)
    • Can be replaced if lost or stolen, providing added security for travelers
• M2 money supply
  • Encompasses all components of M1 (currency, checkable deposits, traveler's checks)
  • Savings deposits
    • Funds held in savings accounts at financial institutions
    • Typically earn interest but may have limitations on withdrawals (monthly limits)
  • Small time deposits
    • Certificates of deposit (CDs) with balances less than $100,000
    • Require a minimum deposit amount and have a fixed maturity date (6-month CD)
  • Money market mutual funds
    • Invest in short-term, low-risk securities such as government bonds
    • Offer check-writing privileges and higher interest rates than traditional savings accounts
  • Near money assets
    • Highly liquid financial instruments that can be quickly converted to cash

Liquidity of money forms

• Liquidity measures the ease and speed of converting an asset into cash without losing value
• Hierarchy of liquidity (most to least liquid)
  1. Currency (cash and coins)
     • Immediately available for use in transactions
     • Accepted as a medium of exchange by all sellers
  2. Checkable deposits
     • Easily accessible through checks, debit cards, or online transfers
     • Funds can be quickly withdrawn or used for payments
  3. Traveler's checks
     • Can be converted into cash at banks or used for purchases
     • Provide security and convenience for travelers
  4. Savings deposits
     • Can be withdrawn from savings accounts, but may have some limitations
     • Funds are generally accessible within a short time frame (1-2 business days)
  5. Small time deposits (CDs)
     • Require a fixed holding period before funds can be withdrawn without penalty
     • Less liquid than savings deposits due to time constraints
  6. Money market mutual funds
     • Can be redeemed for cash, but may involve transaction costs or delays
     • Less liquid than other forms of money due to investment nature
• Factors affecting liquidity
  • Accessibility
    • Ease of converting the asset into usable cash
    • Physical currency is the most accessible form of money
  • Stability of value
    • Likelihood of the asset maintaining its face value during conversion
    • Cash and checkable deposits have the most stable values
  • Transaction costs
    • Fees or penalties incurred when converting the asset into cash
    • Early withdrawal penalties on CDs reduce their liquidity

Banking changes and money measurement

• Electronic payment systems
  • Debit cards
    • Linked to checking accounts and allow for immediate fund transfers
    • Used for point-of-sale transactions and online purchases (Visa, Mastercard)
  • Credit cards
    • Extend short-term loans to consumers for purchases
    • Balances are repaid at a later date, often with interest charges
  • Mobile payment apps
    • Facilitate peer-to-peer transactions and online payments (Venmo, Cash App)
    • May be linked to bank accounts or credit cards for funding
• Impact on money measurement
  • Growing use of electronic payments reduces demand for physical currency
  • Electronic transactions may not be immediately captured in money supply data
    • Credit card balances are excluded from M1 and M2 until paid off
  • Faster transaction processing speeds up the velocity of money circulation
• Challenges for central banks
  • Updating money supply definitions to include emerging digital money forms
  • Monitoring and regulating the use of cryptocurrencies (Bitcoin, Ethereum)
  • Ensuring accurate and timely reporting of money supply data in a digital economy

Banking System and Money Creation

• Monetary base
  • Consists of currency in circulation and bank reserves
  • Forms the foundation for money creation in the banking system
• Fractional reserve banking
  • Banks keep only a fraction of deposits as reserves and lend out the rest
  • Enables banks to create money through the lending process
• Financial intermediation
  • Banks act as intermediaries between savers and borrowers
  • Facilitates the efficient allocation of capital in the economy
• Broad money
  • Includes M2 and other less liquid financial assets
  • Provides a comprehensive measure of money supply in the economy