MEASURING THE MONEY SUPPLY (M1, M2)

The money supply (stock) refers to the total volume of money held by the general public at any given time.

Money serves four functions, as we noted In our previous post.

First and foremost, it functions as a medium of exchange. Secondly, it is a store of value. Thirdly, it is a unit of account. Lastly, it is a standard of deferred payments.

Fortunately or unfortunately, many assets in our world today perform these four functions.

To deal with the issue of multiple money, economists divided these assets into two categories: M1 (transaction money) and M2 (broad money), although some countries have recently added a third: M3.

M1 (Transaction money)

M1 are monies that can be directly used for the transaction. Currency, checkable deposits, and overnight deposits are all part of the M1 supply.

1. currency: this primarily consists of coins and paper money held outside banks. while coins constitute an insignificant portion m1 money supply, paper money constitutes a significant portion of the M1 money supply. 

Indeed, paper money made up over 40% of the M1 money supply.

2. Checkable deposits: The safety of using cheques has now made checkable deposits the most important type of money in most economies.

A checkable deposit is any deposit account with a bank or other financial institutions on which can be written on demand. Checkable deposits include automatic transfer savings accounts, demand deposits, etc.

The reason why checkable deposits are considered parts of the money supply is that they can easily be used as a medium of exchange via checks.

Before we move to the M2 money supply, you should note that currency owned by the commercial banks is excluded from the M1 money supply. The reason is to double-counting things which could lead to double counting.

3. Overnight deposit: As the name seems to suggest, overnight deposits are funds that are placed or borrowed overnight.

It comprises both transferable and non-transferable deposits that are converted by the close of the business day

M2 (broad money)

This includes all M1 money plus other near-monies. Near monies are close substitute for transaction money. 

It includes savings accounts, money market account, certificate of deposits, overnight reports, and other near monies

1. Savings deposits: These include all deposits in savings accounts.

Savings account are interest-bearing accounts with no set maturity date and a maximum balance.

Savings accounts allow you to withdraw money from an automatic teller machine.

However, savings account holders are not allowed to write a check directly.

2. Money market account: These are savings deposit account that pays interest based on current money market rates.

A money market account usually pays a higher interest than a normal savings account and personal balances in a money market account are counted as m2 component of the money supply 

3. Certificate of deposit: This is an account that offers higher interest rates in exchange for customers agreeing to leave a predetermined amount of money untouched for a fixed length of time.

All certificates of deposits are considered M2 components of the Money supply.

4. Overnight repurchase agreement: This is a repurchase agreement in which securities are sold with the expectation of being repurchased the following day.

Overnight repurchase agreements (or overnight repos as they are fondly called) are mostly used by financial institutions for raising short-term funds.

So basically, the M2 money supply is

M2=M1+Savings deposits+money market account+certificate of deposits+ overnight repurchase agreement+other near monies

Although these M2 money supply does not directly function as a medium of exchange, they can be readily converted into currency or checkable deposits without financial loss.

For example, you can easily convert your savings account into cash or transfer funds from your savings account to your checking account.

RELATED POSTS

Money Supply: A Warning 😕

Because many financial instruments reassemble money in some ways, some economists have advocated including all of them in the money supply.

However, because, they are no hard and fast rules for determining what really constitute money, economist and policymakers alike faced a problem when trying to figure out the total value of many supplies.

For our purpose, we will simply define money supply as the sum of M1 and M2.

However, keep in mind that some countries used M0, M3, and M4 as a measure of the money supply.

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