Since we are trying to “count” the money supply in the financial system at a particular point in time, this can also be thought of as the money supply at a particular date. We start with a narrow definition of the money supply, referred to as M1, and then consider M2, which is a broader definition.
M1 Money Supply
The M1 definition of the money supply includes only types of money that perform this basic function. More precisely, the M1 money stock consists of currency, travelers’ checks, demand deposits, and other checkable deposits with depository institutions.
All four components are types of credit money. Currency is the physical money of the United States in the form of coins and paper money. Coins are token money and paper currency is fiat money in the form of Federal Reserve Notes. However, U.S. currency (both coins and paper money) is readily accepted for payments and the repayment of debts and therefore serves as an important medium of exchange.
Cash accounts for nearly 43 percent of the M1 money supply. Travelers’ checks, offered by banks and other organizations, promise to pay the face value of the checks on demand, although their acceptance depends on the creditworthiness of the drawer.
Because travelers’ checks are a widely accepted medium of exchange, they can be considered a component of the M1 money supply. Nevertheless, their relative importance is small, as indicated by the fact that they account for considerably less than 1 percent of the total M1 money supply.
As mentioned above, demand deposits (checking accounts) at commercial banks and other checkable deposits at savings and loan associations, savings banks, and credit cooperatives are also considered credit money, as these deposits are covered solely by the creditworthiness of the issuing institutions when the checks are presented for cashing.
Demand deposits at commercial banks account for more than 40 percent of the money supply. Other checkable deposits account for more than 16 percent of M1 and include accounts with automatic transfer service (ATS) and negotiable withdrawal orders (NOW) at depository institutions, bill accounts at credit unions, and demand deposits at S&Ls, credit unions, and savings banks.
Taken together, demand deposits and other checkable deposit accounts account for slightly less than half of the M1 money supply. This high percentage highlights the importance of the banking system and its money-creating function within the monetary system and with respect to the U.S. financial system in general.
Before moving to a broader definition of the money supply, we should point out some of the adjustments or exclusions that are made in estimating M1 or the money supply. M1 measures transaction balances.
These are amounts of money that can be spent without first converting them into another asset and are held for expected or unanticipated purchases or payments in the immediate future. Essentially, only amounts representing the purchasing power of entities in the U.S. economy other than the federal government are counted.
Expressly excluded from M1 is currency held in the vaults of depository institutions or held by the Fed and the U.S. Treasury.
Demand deposits with depository institutions, the federal government, and foreign banks and governments are also excluded. Adjustments are also made to avoid double counting of processed checks. Vault money and deposits of depository institutions do not represent purchasing power and therefore are not money.
M2 Money Supply
The Fed’s second definition of the money supply, M2, is a broader measure than M1 because it emphasizes money’s function as a medium of exchange as well as a store of value.
Broadly speaking, M2 includes M1 plus highly liquid financial assets, including savings accounts, retail investor deposits, and retail money market funds. Most of the financial assets added to M2 offer their holders a higher return than the M1 components.
More specifically, M2 adds to M1 savings deposits (including money market accounts), small-denomination time deposits (less than $100,000) less balances in individual retirement accounts (IRA) and Keogh accounts at depository institutions, and balances in retail money market funds (MMMFs) less IRA and Keogh balances at money market funds.
In December 2015, the Fed reported M2 at $12,425.0 billion, about four times M1. Some of the owners of the assets included in M2 hold them as long-term savings instruments.
Other individuals and businesses hold these M2-specific assets even though they plan to spend the funds within a few days because the assets are very liquid. Thus, M1 understates purchasing power by the amount of these M2 assets held for transaction purposes.
The components of M2 illustrate the difficulties the Fed has had in delineating these definitions. Money market accounts (MMDAs), for example, offer the privilege of writing checks and thus can be used for transaction purposes.
Some analysts argue on this basis that MMDA balances should be part of M1. The Fed has included MMDA balances in M2 but not in M1 because MMDAs are different from traditional money components and because MMDAs appear to be used more as savings instruments than as transaction balances.
On the other hand, it can be argued that small-time deposits should be excluded from M2 because they are not very liquid in practice. Holders of small-time deposits who wish to redeem them before maturity are penalized by having to forfeit some of the interest earned.
However, small-time deposits are included because they are considered a close substitute for some of the other savings instruments included in M2. Savings deposits, including money market paper, at depository institutions, are larger than the sum of M1.
Money market mutual funds (MMMFs) issue shares to customers and invests the proceeds in highly liquid, interest-bearing debt instruments with very short maturities, known as money market investments. Money market funds get their name from the type of investments they make.
The nature of the investments and the daily interest payment ensure that MMMF shares are valued at $1. Many MMMFs allow shareholders to write checks on their accounts. When the checks clear and are presented to the MMMF for payment, the number of shares the shareholder owns is reduced accordingly.
This process is, of course, very similar to the issuance of checks against checkable deposits held at depository institutions. However, the Fed has decided not to include retail money market fund balances in M1, but rather to use the accounts as a reservoir of purchasing power rather than as a medium of exchange.
Exclusions from the Money Supply
The Fed excludes certain stores of value and borrowings from its money supply definitions. For example, stock and bond mutual funds held by individuals represent stores of value, and some even permit limited check writing against these accounts.
However, because the value of shares in these funds often fluctuates widely and individuals may hold these security investments for a long time, the Fed does not consider these to be part of the money supply.
Credit cards provide predetermined credit limits to consumers at the time the cards are issued. No checkable or other deposits are established at the time of issue. Thus, neither credit card limits nor outstanding balances are part of the money supply. Rather, credit cards just allow their holders to borrow up to a predetermined limit.
However, the use of credit cards can affect the rate of turnover of the money supply and may contribute to money supply expansion. If credit card borrowing stimulates the demand for goods and services, a given money supply can support a higher level of economic activity.
Also, when you use your credit card to purchase a product for, say, $50 at a retailer, the bank that issued the credit card lends you $50 and increases the retailer’s demand deposit account by $50.
As your credit card balance increases as you purchase goods and services on credit, the checkable deposit accounts of those who sold the goods and services also increase. Of course, users of credit cards must eventually pay off their debts.
Money Supply and Economic Activity
Many economists believe that the money supply plays a role in trying to control economic activity. They have observed that economic activity, the money supply, and the price level of goods and services generally evolve together over time. However, economists disagree on how to explain these relationships.
The output of goods and services in the economy is called gross domestic product (GDP). Since we usually measure output in current dollars, we measure “nominal” GDP.
Some economists, known as monetarists, believe that the amount of money in circulation determines the level of GDP or economic activity. If we divide GDP by the money supply (MS), we get the number of times the money supply circulates to produce GDP.
Economists refer to the circulation of money as the velocity of money. More precisely, the velocity of money in circulation measures the velocity of circulation of the money supply.
For example, if the annual GDP is $15 million and the MS is $5 million, the velocity of money (VM) is three times (i.e., $15 million/$5 million). In an alternative form, we can say that,
MS × VM = GDP
For our example, we have,
$5 million × 3 = $15 million
Economists also express nominal GDP as being equal to real output (RO) times the price level (PL) of goods and services, or,
RO × PL = GDP
For example, if the real output in the economy is 150,000 products and the average price is $100, the GDP is $15 million (i.e., 150,000 × $100). Putting these two equations together, we have,
MS × VM = RO × PL
An increase in the money supply and/or velocity causes nominal GDP to increase. And, for nominal GDP to increase, real output and/or price levels must increase. For example, let’s assume the money supply increases by 10 percent, or $500,000, to $5.5 million while the velocity stays at three times. Nominal GDP will increase to,
$5.5 million × 3 = $16.5 million
Since GDP equals RO × PL, some change in real output or price level (or a combination of the two) needs to take place. One possibility is for real output to increase by 15,000 products or units to 165,000 with no change in prices. GDP then would be,
165,000 units × $100 = $16.5 million
Monetarists also believe that if the money supply exceeds the quantity of money demanded, the public will spend more money, causing real economic activity or prices to rise. Too rapid growth of the money supply will eventually lead to rising prices, or inflation, as the excess money is used to drive up the prices of existing goods.
Recall that inflation is an increase in the prices of goods and services that is not offset by improvements in quality. Since it is difficult to measure changes in quality, a more operational definition of inflation is a continuous increase in prices.
Rather than the $1.5 million increase in GDP from $15 million to $16.5 million being due to a 10 percent increase in the money supply, the increase could be due solely to inflation. Let’s assume that the quantity of products sold remains at the original 150,000-unit level but that the average price increases by 10 percent to $110. GDP would be calculated as,
150,000 units × $110 = $16.5 million
Of course, there could be almost unlimited combinations of real outputs and price levels, including lowering one of the variables, that could generate the same new GDP.
Other economists, known as Keynesians in honor of John Maynard Keynes, believe that a change in the money supply is less directly related to GDP. They argue that a change in the money supply first causes a change in the level of interest rates, which in turn changes the demand for goods and services.
For example, an increase in the money supply could cause interest rates to fall (at least initially) because more money is being supplied than demanded.
Lower interest rates, in turn, lead to an increase in consumption and/or investment spending, which increases GDP. In contrast, a decline in the money supply is likely to lead to an increase in interest rates. As a result, GDP will grow more slowly or even contract, depending on how higher interest rates affect consumption and spending decisions.
As you can imagine, it is not possible to say that one group of economists (monetarists or Keynesians) is right and the other is wrong.
The ability to discern relationships between GDP, the money supply, and the price level has been complicated by the fact that the velocity of money in circulation has increased and the various measures of the money supply have grown at different rates.
The velocity of circulation of M1 has increased as the use of credit cards has replaced the more traditional use of cash and deposits in the purchase of goods and services.
The velocity of circulation of M1 money has also increased as the public has made greater use of money market funds and other liquid accounts that serve as stores of value, compared with the use of traditional deposits in demand and other checking accounts.
Recent developments have made it difficult to interpret the short-term effects of changes in the money supply. Decreasing regulation and increasing competition among financial institutions have led to changes in the types of deposit money that individuals use as a medium of exchange.
The ways in which individuals use near-cash accounts as stores of value are also constantly changing. Thus, recent changes in growth rates for the various definitions of the money supply reflect, in part, changes in the way private individuals pay bills and store purchasing power. This is one of the reasons why the Fed simultaneously tracks more than one measure of the money supply.
Some economists believe there is a “psychological” factor that affects the relationship between money supply and economic activity. Increasing the money supply does not automatically lead to higher GDP.
Businesses and individuals may choose not to borrow cheaply because of perceived uncertainty about future economic conditions. Some view the practice of increasing the money supply and liquidity as “trying to pull a string” to increase economic activity.
When businesses and individuals choose not to increase investment and spending, the link between money supply and GDP can be difficult to observe.
As a result of the economic downturn in 2001 and the terrorist attacks of September 11, 2001, the Federal Reserve attempted to maintain financial liquidity by further increasing the M1 and M2 money supply and lowering the federal funds rate to historically low levels.
In the second half of the decade of the 2000s, monetary easing continued in response to the 2007-08 financial crisis and the 2008-09 Great Recession.