- Explain the difference between M1 and M2 money supply and how they are measured
- Explain how banks act as intermediaries between savers and borrowers
- Explain the structure and key functions of the Federal Reserve
- Explain how the Federal Reserve System implements monetary policy
Measuring and Tracking the Money Supply
Now that you have a good understanding of money, what qualifies as money, and how money facilitates exchanges between buyers and sellers, we need to look at how money evolves from a medium of exchange to a system. There was a time in the United States when there was no monetary system, and buyers and sellers who traveled from state to state had to carry multiple currencies. The Confederate States of America dollar was issued by the newly formed confederacy just before the outbreak of the American Civil War. It wasn’t backed by hard assets (i.e., commodities) but simply by a promise to pay the bearer after the war, on the prospect of Southern victory and independence. Alabama, Arkansas, Florida, Georgia, Louisiana, Mississippi, South Carolina, Tennessee, Texas, and Virginia each printed and circulated currency that had value only within the state. It was not until 1863 when President Lincoln signed the National Banking Act that the federal dollar was established as the sole currency in the United States.
What about other kinds of currency? Cash in your wallet certainly serves as money, but how about checks or credit cards? Are they money, too? Rather than trying to determine a single way of measuring money, economists offer broader definitions of money based on liquidity. Liquidity refers to how quickly a financial asset can be used to buy a good or service. For example, cash is very liquid. Your $10 bill can easily be used to buy a hamburger at lunchtime. However, $10 that you have in your savings account is not so easy to use. You must 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. It’s responsible for monetary policy, and it defines money according to its liquidity. You will learn more about the Federal Reserve System in the next section. There are two definitions of money: M1 and M2 money supply. M1 money supply includes those monies that are very liquid such as cash, checkable (demand) deposits, and traveler’s checks. M2 money supply is less liquid in nature and includes M1 monies plus savings and time deposits, certificates of deposits, and money market funds.
M1 money supply includes coins and currency in circulation—the coins and bills that circulate in an economy that are not held by the U.S. Treasury, 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 a check is written or a debit card is used. These items together—currency, and checking accounts in banks—comprise the money defined as M1, which is measured daily by the Federal Reserve System. Traveler’s checks are also included in M1 but have recently decreased in use.
M2 is a broader category of money. It includes everything in M1 but also adds other types of deposits. For example, M2 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. Many banks and other financial institutions also offer a chance to invest in money market funds, where the deposits of many individual investors are pooled together and invested in a safe way, such as in short-term government bonds. Another portion 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 are money that you can withdraw and spend, but which require a greater effort to do so than the items in M1. Figure 1, below, should help you visualize the relationship between M1 and M2. Note that M1 is included in the M2 calculation.
The Federal Reserve System is responsible for tracking the amounts of M1 and M2 and prepares a weekly release of information about the money supply. For example, according to the Federal Reserve Bank’s measure of the U.S. money stock, at the end of February 2015, M1 in the United States was $3 trillion, while M2 was $11.8 trillion. A breakdown of the portion of each type of money that comprised M1 and M2 in February 2015, as reported by the Federal Reserve Bank, is provided in Table 1.
|Components of M1 in the U.S. (February 2015, seasonally adjusted)||$ billions|
|Demand deposits and other checking accounts||$1,713.5|
|Total M1||$2,988.2 (or $3 trillion)|
|Components of M2 in the U.S. (February 2015, seasonally adjusted)||$ billions|
|M1 money supply||$2,988.2|
|Individual money market mutual fund balances||$610.8|
|Total M2||$11,820.3 (or $11.8 trillion)|
The lines separating M1 and M2 can become a little blurry. Sometimes elements of M1 are not treated 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 in M2 more similar to the checking accounts in M1. 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 “plastic money” like debit cards, credit cards, and smart money 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. It is important to note that in our definition of money, it’s checkable deposits that are money, not the paper check or the debit card. Although you can make a purchase with a credit card, it is not considered money but rather a short term loan from the credit card company to you. When you make a purchase with a credit card, 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. With a smart card, you can store a certain value of money on the card and then use the card to make purchases. Some “smart cards” used for specific purposes, like long-distance phone calls or making purchases at a campus bookstore and cafeteria, are not really all that smart, because they can only be used for certain purchases or in certain places.
In short, credit cards, debit cards, and smart cards are different ways to move money when a purchase is made. But having more credit cards or debit cards does not change the quantity of money in the economy, any more than having more checks printed increases the amount of money in your checking account.
One key message here is that counting and tracking the money in a modern economy doesn’t just involve paper bills and coins; instead, money is closely linked to bank accounts. Indeed, the macroeconomic policies concerning money are largely conducted through the banking system. The next section explains how banks function as an intermediary to financial transactions.
Banks As Financial Intermediaries
The late bank robber named Willie Sutton was once asked why he robbed banks. He answered: “That’s where the money is.” While this may have been true at one time, from the perspective of modern economists, Sutton is both right and wrong. He is wrong because the overwhelming majority of money in the economy is not in the form of currency sitting in vaults or drawers at banks, waiting for a robber to appear. Most money is in the form of bank accounts, which exist only as electronic records on computers. From a broader perspective, however, the bank robber was more right than he may have known. Banking is intimately interconnected with money and, consequently, with the broader economy.
Banks make it far easier for a complex economy to carry out the extraordinary range of transactions that occur in goods, labor, and financial capital markets. Imagine for a moment what the economy would be like if all payments had to be made in cash. When shopping for a large purchase or going on vacation, you might need to carry hundreds of dollars in a pocket or purse. Even small businesses would need stockpiles of cash to pay workers and to purchase supplies. A bank allows people and businesses to store this money in either a checking account or savings account, for example, and then withdraw this money as needed through the use of a direct withdrawal, writing a check, or using a debit card.
Banks are a critical intermediary in what is called the payment system, which helps an economy exchange goods and services for money or other financial assets. Also, people with extra money that they’d like to save can store their money in a bank rather than look for an individual who is willing to borrow it from them and then repay them at a later date. Those who want to borrow money can go directly to a bank rather than trying to find someone to lend them cash. Thus, banks act as financial intermediaries—they bring savers and borrowers together.
An intermediary is one who stands between two other parties. Banks are a financial intermediary—that is, an institution that operates between a saver who deposits money in a bank and a borrower who receives a loan from that bank. All the funds deposited are mingled in one big pool, which is then loaned out. Figure 1 illustrates the position of banks as financial intermediaries, with deposits flowing into a bank and loans flowing out.