Question

1. Does each of the following belong in M1 or M2, both or neither? Why?

1. $500 in cash?
2. $ 500 I have in a CD?
3. 20 shares of IBM stock worth $2,000?
4. When I take out $100 from my savings account?

If the V (Velocity) is constant and the real output (Y) is constant and the Fed doubles the money supply (M), what will be the outcome? Show all work.

Answer 1

M1 includes coins and currency that circulate in the US economy but not held by the US treasury. This also includes checkable deposits (for which you can write a check) and traveler's checks.

M2 is everything in  M1 + savings deposits + money market funds + certificates of deposit + other time deposits.

a) Since $500 cash is currency it will be in M1 if it is in circulation. And since M2 included everything in M2, this will belong to M2 as well.

b) CD or certificate of deposit, also known as time deposits are accounts when the depositor has left the money in a bank for a certain period of time in return of a higher rate of interest. A CD restricts access to the funds until the maturity date of the investment. This belongs to M2.

c) Stocks and bonds do not belong to either M1 and M2. Therefore 20 shares of IBM stock is not a part of M1 or M2.

d) One the money has been withdrawn from the savings account, it is cash and no longer a part of saving deposits. Therefore it belongs to M1. But since M1 also forms a part of M2, this $1000 cash is also a part of M2.

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The velocity of money and real output follows the equation :

MV = PY

where M is the money supply, V is the velocity of money, P is the price and Y is the real output.

This can also be written as:

M/M + V/V = P/P + ​​​​​​​Y/Y

where ​​​​​​​M/M represents the change in money supply, ​​​​​​​V/V is change in velocity of money, ​​​​​​​P/P is change in prices and ​​​​​​​Y/Y is the change in real output.

Since velocity and output is constant hence ​​​​​​​V/V and ​​​​​​​Y/Y = 0.

Therefore: M/M = P/P

Since money supply is doubled, M/M = 2. Therefore P/P = 2.

Hence price level will also double. ----------> Answer