Chapter 9.2: Measuring Money

9.2 Measuring Money: Currency, M1, and M2

Learning Objectives

By the end of this section, you will be able to:

• Contrast M1 money supply and M2 money supply
• Classify monies as M1 money supply or M2 money supply

M1 and M2 money

Cash in your pocket certainly serves as money; however, what about checks or credit cards? Are they money, too? Rather than trying to state a single way of measuring money, economists offer broader definitions of money based on liquidity. Liquidity refers to how quickly you can use a financial asset to buy a good or service. For example, cash is very liquid. You can use your $10 bill easily to buy a hamburger at lunchtime. However, it is not as easy to use that $10 that you may have in your savings account. You need to go to the bank or ATM machine and withdraw that cash to buy your lunch. Thus, $10 in your savings account is less liquid.

The Federal Reserve Bank, which is the central bank of the United States, is a bank regulator and is responsible for monetary policy and defines money according to its liquidity. There are two definitions of money: M1 and M2 money supply. Historically, M1 money supply included those monies that are very liquid such as cash, checkable (demand) deposits (the amounts held in checking accounts), and traveler’s checks, while M2 money supply included those monies that are less liquid in nature; M2 money includes M1 money plus savings and time deposits, certificates of deposits, and money market funds. Beginning in May 2020, the Federal Reserve changed the definition of both M1 money and M2 money. The biggest change is that savings was reclassified as M1 money. M1 money supply now includes cash, checkable (demand) deposits, and savings. M2 money supply is now measured as M1 money plus time deposits, certificates of deposits, and money market funds.

The M1 money supply includes coins and currency in circulation—the coins and bills that circulate in an economy that the U.S. Treasury does not hold at the Federal Reserve Bank or in bank vaults. Closely related to currency are checkable deposits, also known as demand deposits. These are the amounts held in checking accounts. They are called demand deposits or checkable deposits because the banking institution must give the deposit holder his money “on demand” when the customer writes a check or uses a debit card. These items combined—the amount of money held as currency and checking accounts in banks—comprise the definition of money known as M1, which the Federal Reserve System measures daily.

As mentioned, M1 now includes savings deposits in banks, which are bank accounts on which you cannot write a check directly, but from which you can easily withdraw the money at an automatic teller machine or bank.

A broader definition of money, M2 includes everything in M1 but also adds other types of deposits. Many banks and other financial institutions also offer a chance to invest in money market funds, where they pool together the deposits of many individual investors and invest them in a safe way, such as short-term government bonds. Another ingredient of M2 are the relatively small (that is, less than about $100,000) certificates of deposit (CDs) or time deposits, which are accounts that the depositor has committed to leaving in the bank for a certain period of time, ranging from a few months to a few years, in exchange for a higher interest rate. In short, all these types of M2 money are money that you can withdraw and spend, but which require a greater effort to do so than the items in M1. Figure 9.1 should help in visualizing the relationship between M1 money and M2 money. Note that M1 money is included in the M2 money calculation.

“The Relationship between M1 and M2 Money” by OpenStax, is licensed under CC BY 4.0

Figure 9.1 The Relationship between M1 and M2 Money M1 and M2 money have several definitions, ranging from narrow to broad. M1 = coins and currency in circulation + checkable (demand) deposit + savings deposits. M2 = M1 + money market funds + certificates of deposit + other time deposits.

The Federal Reserve System is responsible for tracking the amounts of M1 money and M2 money and prepares a weekly release of information about the money supply. To provide an idea of what these amounts sound like, according to the Federal Reserve Bank’s measure of the U.S. money stock, at the end of December 2023, M1 money in the United States added up to $18.1 trillion, while M2 money added up to $20.8 trillion. Table 9.1 provides a breakdown of the portion of each type of money that comprised M1 money and M2 money in December 2023, as provided by the Federal Reserve Bank.

Table 9.1 M1 and M2 Federal Reserve Statistical Release, Money Stock Measures (Source: Federal Reserve Statistical Release, http://www.federalreserve.gov/RELEASES/h6/current/default.htm#t2tg1link)

Figure 9.2 M1 and M2

The lines separating M1 money and M2 money can become a little blurry. Sometimes businesses do not treat elements of M1 money alike. For example, some businesses will not accept personal checks for large amounts but will accept traveler’s checks or cash. Changes in banking practices and technology have made the savings accounts categorized as M2 money more like the checking accounts in M1 money. For example, some savings accounts will allow depositors to write checks, use automatic teller machines, and pay bills over the internet, which has made it easier to access savings accounts. As with many other economic terms and statistics, the important point is to know the strengths and limitations of the various definitions of money, not to believe that such definitions are as clear-cut to economists as, say, the definition of nitrogen is to chemists.

Where does debit cards and credit cards, fit into this picture? A debit card, like a check, is an instruction to the user’s bank to transfer money directly and immediately from your bank account to the seller. Therefore, a debit card is considered part of M1. Credit cards, on their other hand is not considered part of M1 or M2. Although you can make a purchase with a credit card, the financial institution does not consider it money but rather a short-term loan from the credit card company to you. When you make a credit card purchase, the credit card company immediately transfers money from its checking account to the seller, and at the end of the month, the credit card company sends you a bill for what you have charged that month. Until you pay the credit card bill, you have effectively borrowed money from the credit card company.

One key message underlying this discussion of M1 money and M2 money is that money in a modern economy is not just paper bills and coins. Instead, money is closely linked to bank accounts. The banking system largely conducts macroeconomic policies concerning money. The next section explains how banks function and how a nation’s banking system has the power to create money.

This chapter is a revised version of the chapters 14.2 Measuring Money: Currency, M1, and M2 in Principles of Macroeconomics 3e by OpenStax, published under a Creative Commons Attribution 4.0 International License. Other additions and modifications have been made in accord with the style, structure, and audience of this guide.