Question

in countries with low inflation, monetary growth is a poor forecaster of inflation. Given the definitions of money, M1 and M2, and considering that M2 is the most widely used definition of money in an economic system, can you explain this lesson

Answer 1

The government definition of the money supply actually has several levels, depending on how accessible money is. The level it refers to as "M1" consists of money that people and organizations could spend immediately. Its two main components are currency and deposits.The first part of M1 is U.S. currency that's in circulation -- bills and coins available for spending, both in the United States and abroad. It doesn't include cash held in vaults by the U.S. Treasury Department, the Federal Reserve or financial institutions such as banks and credit unions. That cash isn't counted in M1 because it isn't ready to spend immediately. But coins in your dresser drawer or a wad of bills stuffed under your mattress do count in M1. Even currency that's been buried and long forgotten counts in M1, because as far as the government is concerned, it's still out there somewhere. Dig it up, it's still good. Though not currency, travelers checks are spendable like cash, so they, too, are included in M1.

M1 includes "demand deposits" -- checking accounts, NOW accounts and any other deposits that you can draw upon any time you want. Traditionally, savings accounts, money market accounts and brokerage accounts weren't included in M1, since you couldn't spend the money in them immediately. However, more institutions are making such deposits accessible on demand, such as brokerage houses that allow you to write checks against your investments. So M1 now includes any deposits that are "checkable," meaning you can access the funds with a check, debit card or similar instrument.Cash in bank vaults doesn't get included in M1 because doing so would effectively count the same dollars twice -- once as cash and once as a deposit. Vault cash is there to provide liquidity for customers' deposits. The Federal Reserve requires banks to keep a certain portion of their deposits on hand as cash, so that when you go in to withdraw $100 from your account, there will actually be $100 there for you. When it was sitting in the bank, that $100 was counted as part of the bank's demand or checkable deposits. Once you take it out, it becomes currency in circulation.

M2 is a calculation of the money supply that includes all elements of M1 as well as "near money." M1 includes cash and checking deposits, while near money refers to savings deposits, money market securities, mutual funds, and other time deposits. These assets are less liquid than M1 and not as suitable as exchange mediums, but they can be quickly converted into cash or checking deposits.M2 is a measure of the money supply that includes cash, checking deposits, and easily convertible near money.Measuring the money supply of an economy is a challenging proposition. Due to the complexity of the concept of “money,” as well as the size and level of detail of an economy, there are multiple ways of measuring a money supply. These means of measuring a money supply are typically classified as “M”s and fall along a spectrum from narrow to broad monetary aggregates. Typically, the “M”s range from M0 to M3, with M2 typically representing a fairly broad measure.

M2 is a broader money classification than M1 because it includes assets that are highly liquid but are not cash. A consumer or business typically doesn't use savings deposits and other non-M1 components of M2 when making purchases or paying bills, but it could convert them to cash in relatively short order. M1 and M2 are closely related, and economists like to include the more broadly defined definition for M2 when discussing the money supply, because modern economies often involve transfers between different account types. For example, a business may transfer $10,000 from a money market account to its checking account. This transfer would increase M1, which doesn’t include money market funds, while keeping M2 stable, since M2 contains money market accounts.One key message underlying this discussion of M1 and M2 is that money in a modern economy is not just 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.