Measuring the Money Supply: Explanation and Examples

Measuring the Money Supply: Explanation and Examples
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

Discover how the Federal Reserve defines the money supply by exploring the components of the money stock. In this lesson, we also look at the money supply in terms of function and liquidity.

Measuring the Amount of Money in Circulation

The money supply is the total quantity of money in the economy at any given time. Economists measure the money supply because it is directly connected to the activity taking place all around us in the economy. In addition, the Federal Reserve's Board of Governors and the Federal Open Market Committee use this information as the basis of their monetary policy. What we're talking about in this lesson is: how do we measure the money supply?

While most people think that money supply is one big pile of cash in the economy, economists look at it very specifically. We can define the money supply in three different ways - M1, M2 and M3.

M1 is the narrowest definition of money. M1 consists of coins and currency in circulation, checking accounts and traveler's checks.

M2 is a more broad definition of money than M1. M2 = M1 + small savings accounts, money market funds and small time deposits.

M3 is even more broad and includes M2 + large time deposits, large money market funds and repurchase agreements, which are financial instruments generally used by large businesses and institutions. Since 2006, the Federal Reserve stopped using M3 - so now we have M1 and M2.

These measures correspond to three definitions of money that the Federal Reserve uses.

Here's a snapshot of the money supply at the end of July 2012. As you can see, M1 consists of around $1 trillion in currency, about $4 billion in traveler's checks and another $1.26 trillion in demand deposits at banks. These three make up M1, which totaled about $2.3 trillion. M2 takes M1 and adds several other things to it. When you add savings accounts, small time deposits and small money market funds, you get a total of about $10 trillion, which economists refer to as M2.

The Money Supply in Terms of Function

A sample snapshot of the money supply for one month
M1 M2 Money Supply Chart

Here's another way to think of these two measures of the money supply.

The money in M1 functions as a medium of exchange. When Bob deposits money into his checking account, this is part of M1. He can withdraw this money at any time and use it to buy stuff.

The money in M2 functions as a store of value. When Margie puts $10,000 into her savings account, for example, she's using the money as a store of value. This money will earn interest and help protect the purchasing power of her initial deposit.

The Money Supply in Terms of Liquidity

Finally, we can look at the money supply in terms of liquidity.

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