Money Supply M1 Does Not Include The Currency Held By

The money supply is a critical indicator of an economy's health, influencing interest rates, inflation, and overall economic activity. Understanding the different measures of money supply, such as M1, M2, and M3, is essential for investors, economists, and policymakers alike. Specifically, the composition of M1—and what it doesn't include—provides valuable insights into the liquidity and transactional nature of money circulating in an economy.

Understanding Money Supply

Before delving into the specifics of M1, let's define money supply in broader terms. The money supply refers to the total amount of money available in an economy at a specific time. It includes various forms of money, such as cash, checking accounts, and other liquid assets. Central banks, like the Federal Reserve in the United States, track and regulate the money supply to manage inflation, stimulate economic growth, or stabilize the economy during downturns.

Different measures of money supply reflect varying degrees of liquidity and accessibility. These measures are typically categorized into:

• M0 (Monetary Base): This is the most basic measure, representing the total currency in circulation and commercial banks' reserves held at the central bank.
• M1: A narrow measure that includes the most liquid forms of money.
• M2: A broader measure that includes M1 plus less liquid assets.
• M3: An even broader measure that includes M2 plus certain large deposits and institutional money market funds.

Each of these measures provides a different perspective on the amount of money available for transactions and economic activity. Now, let’s focus on M1 and what it encompasses.

What is M1?

M1 is a narrow measure of the money supply that includes the most liquid forms of money readily available for transactions. It primarily consists of:

• Currency in Circulation: This includes physical money like coins and paper money held by the public.
• Demand Deposits: These are funds held in checking accounts, which can be easily accessed for payments and transactions.
• Other Checkable Deposits: This includes negotiable order of withdrawal (NOW) accounts and automatic transfer service (ATS) accounts, which also allow for immediate withdrawals and payments.

M1 represents the money that is most easily used for day-to-day transactions. It reflects the immediate purchasing power available in the economy.

What M1 Does Not Include

While M1 covers the most liquid forms of money, it excludes several other types of assets that are considered less liquid or not directly used for transactions. The key exclusions from M1 are:

1. Savings Deposits:
   • Savings deposits are funds held in savings accounts at banks and other financial institutions.
   • Unlike demand deposits, savings accounts typically have restrictions on the number of withdrawals or transfers that can be made within a certain period.
   • While savings deposits are relatively liquid, they are not as readily available for transactions as checking accounts, hence their exclusion from M1.
2. Time Deposits (Certificates of Deposit - CDs):
   • Time deposits, such as CDs, are funds deposited for a fixed period at a specific interest rate.
   • CDs cannot be easily accessed before their maturity date without incurring a penalty.
   • Due to their illiquidity and fixed-term nature, time deposits are not included in M1.
3. Money Market Accounts (MMAs):
   • Money market accounts are interest-bearing accounts that offer higher yields than traditional savings accounts.
   • MMAs typically have minimum balance requirements and may limit the number of transactions allowed per month.
   • While MMAs are more liquid than time deposits, they are not as easily accessible for transactions as demand deposits, leading to their exclusion from M1.
4. Institutional Money Market Funds:
   • These are money market funds held by institutional investors, such as corporations and government entities.
   • These funds are not directly used for consumer transactions and are therefore excluded from M1.
5. Currency Held by Banks and Other Financial Institutions:
   • The currency held in bank vaults and ATMs is not considered to be in circulation.
   • This currency is part of the bank's reserves and is not available for transactions in the broader economy.
   • Including this currency in M1 would result in double-counting, as it is already accounted for when it enters circulation.
6. Currency Held by the Government:
   • Currency held by the government is also excluded from M1.
   • This currency is not actively circulating in the economy and is not available for private transactions.
   • Including government-held currency would distort the measure of money available for economic activity.
7. Traveler's Checks:
   • Traveler's checks were once a common form of payment while traveling.
   • However, with the rise of debit and credit cards, their use has declined significantly.
   • While traveler's checks can be used for transactions, their limited use and declining popularity exclude them from M1.

The Role of M1 in Economic Analysis

M1 plays a crucial role in economic analysis and monetary policy. It provides insights into the level of liquidity and transactional activity in the economy. Here’s why M1 is important:

• Indicator of Economic Activity: Changes in M1 can signal shifts in economic activity. A rapid increase in M1 may indicate rising consumer spending and economic growth, while a decline may suggest a slowdown.
• Monetary Policy Tool: Central banks use M1 as one of the indicators to assess the effectiveness of monetary policy. By monitoring M1, central banks can adjust interest rates and reserve requirements to influence the money supply and control inflation.
• Inflationary Pressures: A significant increase in M1 without a corresponding increase in economic output can lead to inflationary pressures. When there is more money chasing the same amount of goods and services, prices tend to rise.
• Liquidity Assessment: M1 provides a snapshot of the economy's liquidity. A high level of M1 indicates that there is ample money available for transactions, which can support economic activity.

Factors Affecting M1

Several factors can influence the level of M1 in an economy:

• Central Bank Policies: Monetary policy decisions made by central banks, such as changes in interest rates and reserve requirements, can directly impact M1. Lowering interest rates can encourage borrowing and increase the amount of money in circulation.
• Government Spending: Government spending and fiscal policies can also affect M1. Increased government spending can inject money into the economy, leading to an increase in M1.
• Consumer Behavior: Consumer spending habits play a significant role in determining M1. Increased consumer spending leads to more transactions and a higher level of demand deposits.
• Banking Sector Activity: The lending and deposit activities of banks influence M1. When banks increase lending, they create new deposits, which add to the money supply.
• Economic Conditions: Overall economic conditions, such as economic growth, inflation, and unemployment, can affect M1. During periods of economic growth, M1 tends to increase, while during recessions, it may decline.

M2 and M3: Broader Measures of Money Supply

While M1 is a narrow measure of the money supply, M2 and M3 provide broader perspectives by including less liquid assets. Understanding these measures helps in gaining a more comprehensive view of the money supply.

M2

M2 includes M1 plus:

• Savings Deposits: As mentioned earlier, these are funds held in savings accounts.
• Time Deposits (CDs) less than $100,000: Small-denomination time deposits are included in M2.
• Money Market Accounts (MMAs): These interest-bearing accounts are also part of M2.
• Retail Money Market Funds: These are money market funds held by individual investors.

M2 is a broader measure of money supply that includes assets that are less liquid than those in M1 but can still be easily converted into cash.

M3

M3 includes M2 plus:

• Large-denomination Time Deposits (CDs) greater than $100,000: These are large time deposits held by institutional investors.
• Institutional Money Market Funds: These funds are held by institutional investors, such as corporations and government entities.
• Repurchase Agreements (Repos): These are short-term borrowing agreements.
• Eurodollars: U.S. dollars held in banks outside the United States.

M3 is the broadest measure of the money supply and includes assets that are less liquid and more complex than those in M1 and M2. However, it's important to note that many central banks, including the Federal Reserve in the United States, have stopped tracking M3 due to its complexity and limited additional insights into economic activity.

The Relationship Between M1, M2, and M3

The different measures of money supply—M1, M2, and M3—are related but provide different perspectives on the amount of money available in the economy. M1 focuses on the most liquid forms of money used for transactions, while M2 and M3 include less liquid assets.

• M1 as a subset of M2 and M3: M1 is a component of both M2 and M3. This means that any increase or decrease in M1 will also affect M2 and M3.
• Hierarchy of Liquidity: The measures represent a hierarchy of liquidity, with M1 being the most liquid, followed by M2 and then M3.
• Economic Insights: Each measure provides unique insights into economic activity. M1 is closely watched as an indicator of transactional activity, while M2 and M3 provide a broader view of the overall money supply.

Real-World Examples

To illustrate the concepts discussed, let’s consider some real-world examples:

1. Impact of Interest Rate Changes:
   • If the Federal Reserve lowers interest rates, borrowing becomes cheaper.
   • This can lead to an increase in demand for loans, resulting in more money being created and added to demand deposits (part of M1).
   • Consequently, M1 increases, indicating a potential boost in economic activity.
2. Government Stimulus:
   • During an economic downturn, the government may implement a stimulus package, such as sending out checks to households.
   • When people deposit these checks into their checking accounts, demand deposits increase, leading to a rise in M1.
   • This injection of money can stimulate spending and help revive the economy.
3. Shift in Consumer Behavior:
   • If consumers become more confident about the economy, they may start spending more and holding less money in savings accounts.
   • This shift from savings accounts (part of M2) to checking accounts (part of M1) can increase M1 while potentially decreasing M2.
   • Such a shift indicates a greater willingness to engage in transactions.

Criticisms and Limitations of M1

While M1 is a valuable measure of the money supply, it has some limitations:

• Narrow Focus: M1 only captures the most liquid forms of money and may not provide a complete picture of the overall money supply.
• Technological Changes: The rise of digital payments and cryptocurrencies has blurred the lines between different forms of money. Traditional measures like M1 may not fully capture the impact of these new forms of payment on the economy.
• Instability of Relationship with Economic Activity: The relationship between M1 and economic activity can be unstable over time. Factors such as changes in financial regulations and consumer preferences can weaken the correlation between M1 and economic growth.
• Exclusion of Credit: M1 focuses on money readily available for transactions but does not account for credit. Credit plays a significant role in economic activity, and excluding it from M1 may limit its usefulness in assessing the overall financial health of the economy.

Conclusion

Understanding the money supply, particularly M1, is essential for analyzing economic activity and formulating effective monetary policy. M1 includes currency in circulation, demand deposits, and other checkable deposits, representing the most liquid forms of money available for transactions. However, it excludes savings deposits, time deposits, money market accounts, and currency held by banks and the government.

While M1 provides valuable insights into the transactional nature of money in the economy, it is important to consider its limitations and complement it with broader measures like M2 and M3. By monitoring these measures, economists and policymakers can gain a more comprehensive understanding of the money supply and its impact on economic growth, inflation, and overall financial stability. As the financial landscape continues to evolve with the rise of digital currencies and new payment technologies, it will be crucial to adapt and refine our measures of money supply to accurately reflect the changing dynamics of the economy.