Lesson 4 of 19
There are two official measures of money known as M1 and M2.
According to New York Fed:
The money supply measures reflect the different degrees of liquidity—or spendability—that different types of money have. The narrowest measure, M1, is restricted to the most liquid forms of money; it consists of currency in the hands of the public; travelers checks; demand deposits, and other deposits against which checks can be written. M2 includes M1, plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds.
These two forms of money are summarized in the below table:
| M1 | M2 | |
|---|---|---|
| Currency and traveler's checks | Yes | Yes |
| Checking deposits | Yes | Yes |
| Time deposits | Yes | |
| Savings deposits | Yes | |
| Money market mutual funds and other deposits | Yes |
The European Central Bank has defined a narrow aggregate (M1), an "intermediate" aggregate (M2) and a broad aggregate (M3). These aggregates differ with regard to the degree of moneyness of the assets included. The following table summaries this:
| M1 | M2 | M3 | |
|---|---|---|---|
| Currency in circulation | X | X | X |
| Overnight deposits | X | X | X |
| Deposits with an agreed maturity up to 2 years | X | X | |
| Deposits redeemable at a period of notice up to 3 months | X | X | |
| Repurchase agreements | X | ||
| Money market fund (MMF) shares/units | X | ||
| Debt securities up to 2 years | X |
Quantity Theory of Money
The quantity theory of money states that the money supply has a direct relationship with the price levels.
If P is the price levels, and Q is the real output, then P*Q is the total spending. If M is the money supply, then:
M*V = P*Q
V is the velocity, that is, the number of times each unit of money is used to buy goods and services.
This equation is called the equation of exchange.
This equation helps us understand the relationship between money supply and price levels. Assume that the real output and velocity remains constant, a 10% increase in money supply will result in a 10% increase in average price levels. This is the reason why monetarists believe that monetary policy can be used to control inflation.