Definition, measurement, and functions of money
Money supply: M0, M1, and M2
What I want to explore in this video is the different ways of measuring the amount of money we have in circulation. So we're going to start things with our Central Bank in the US. This would be the US Federal Reserve. And let's say that they print $4. And we're going to focus, just for visualization purposes, on that they're doing it physically. They could also do it electronically. But we're just going to focus on the physical. And the way that they get this into circulation is it they'll take these $4 and they'll go buy securities in the open market, normally very safe and very liquid securities. Liquid means it's very easy to buy and sell those securities in large quantities. For example, government treasuries is a liquid security, or liquid asset. PEZ dispensers would not be a liquid asset. If I bought a billion dollars worth of PEZ dispensers it would be very hard for me to sell-- one it would be very hard for me to buy a billion dollars worth. And it would be even probably even harder for me to sell a billion dollars worth in any short or medium timeframe. So the Central Bank goes out, and let's say they go and buy one liquid security for $4. So this is a security right over here. And the person that they bought the security from decides to deposit it in a bank. They could either directly deposit it in a bank or they could use that money that they got from selling their security to buy things, and the person they bought things from could deposit it in a bank. But one way or another we can imagine it all gets deposited in a bank. So this is our private bank. I'll call this private bank number one. So now all of these dollars are transferred to private bank number one. And they are no longer-- the Federal Reserve, or the Central Bank, in the general case, is no longer in possession of them. They've been transferred right over here. And I want to cross these out just so we can keep track of things. Now when they deposit it in private bank number one, they said, well, I need three of these dollars on demand. And I want to write checks against them. So they put three of these dollars in a checking account. There are at three of these dollars a checking account. So checks up too-- so write checks up to $3. And so they can get a little bit more interest, and the bank's willing to give a little bit more interest on a savings account because they don't have to keep the reserves, they put $1 into a savings account. And they cannot write checks against that savings account. Now there are special circumstances now, but for simplicity, let's just say that they cannot write checks. There are some that have restricted check writing and things like that now. So this bank says, OK, well, this dollar, I don't have to even have any reserves against it. I could loan out this dollar. And the person they lend it to, let's say that they immediately go and deposit it into another bank. So they immediately go and deposit this in private bank, I'll call this private bank two. So it's no longer in private bank one. Let me draw a private bank two. Private bank two is a right over here. Private bank number two. And they deposit it into a savings account in private bank number two. And let's say all of this, out of all of this, the bank says, well, this is a demand deposit, I have to keep some reserves. This is a fractional reserve system. But I can lend out, in the US, I could lend out up to 90% of this. And maybe this bank is a little bit more conservative, They only lend out 2/3 of this. So they lend out $2 out of these $3 And let's say the person they let it do also happens to deposit it in private bank number two, just coincidentally. So these two also end up in private bank number two. And so they're no longer in private bank number one, although this person could still write checks up to $3. And now here in private bank number two-- and let's say these are deposited in a checking account. These are deposited right over here in a checking account. Now private bank number two, it can do a couple of things. In this checking account it has to keep some reserves. Let's say it's even more conservative. It only decides to lend out half of this, even though it could lend out 90%. And so it lends out one of these dollars. And the person that they lend it to just takes that dollar and they put it in their wallet. So they just put it in their wallet. And they could also lend out this entire savings. And let's just say that the person that they lend that $1 in savings to also puts it in their wallet. And notice, the original $4 are still there. One, two, three, four. Now, and just to be clear, this person right over here can write checks up to $3 . And this person right over here can write checks-- let me do that same checking account color-- they can write checks up to $2. Now let's think about the different forms of money there are here. Well, we could think of money in a very, very narrow way, which is just what did the Central Bank print, or create electronically as electronic reserves of its member banks? But for simplicity here you can just think about the physical currency that it printed, its base money. And so that, often, is just referred to as base money. And in the US and other countries it's often the same thing as M0. There's slight differences from country to country. And in this example, as soon as they printed it and put it into circulation, that was $4. We had $4 of base money. And that's obvious because as soon as they printed this and they bought the security with it, and it was in circulation, that $4 could be used to buy things. It could be used to facilitate transactions. Now that clearly isn't all of the stuff that can be used as money in this little universe we created. This guy, you have the $4 but these people can also write checks right over here. And so we can have a slightly broader definition of money. And over here, we will call it M1. And here, there's a couple of ways you could think about it. You could think about it as all of the currency that's in people's pockets plus all of the check writing capabilities. So if you view it that way it, would be this $2 plus $5 of check writing capabilities right over here. So you could have $2 of physical currency that's in people's wallets, not in bank reserves, plus the $5 of check writing capability, which would give you $7. Another way you could view it, you could view it as M0 plus checkable deposits. I'll just write checks here, plus-- well I'll write-- checkable deposits. But if you do that, you are now double counting because some of the M0 is reserves in the checkable deposits. Or you could say some of the checkable deposits is held as reserves for M0. So then you would have to subtract out the bank reserves. And so then you would get $4 because we don't want to double count these right over here. You would get M0 is $4. And I want to do that in white. M0 is $4. The checkable deposits is $5. Let me do that in the pink. Plus the $5. And then you would want to subtract out the reserves. And the reserves here, there are $2 of the reserves. So minus $2. And you would get yourself back to the $7. And the whole point of this is so you're not double counting something, you're not double counting this right over here, as part of checkable deposits and part of the M0. You're not using this twice. It's not part of the base money. It is both the base money and checkable deposits. And we don't want to count it twice. So the simplest way to think about is, well, what can be used in this broader definition to facilitate transactions? These $2 in people's pockets, and this ability to write up to $5 of checks. So that's this view right over here. And if we want to get even broader than that, we can get to something called M2. And here we could say, OK, what's immediately usable to facilitate a transaction right now? So that would be our M1. So that would be our $7 of M1. Plus things that can be easily converted to M1. So for example, these savings accounts can be easily converted to checking accounts. It might only take a couple of days. There might be some restrictions. But it can be converted. And when it gets converted will change the bank's reserve requirements a little bit. But it will allow, if this person converts it they will have the ability to write more checks. So M2 includes M1 plus things that are very easy to convert to M1. And so they'll include things like savings accounts, money market accounts, which I won't go into detail here. But they're really kind of similar in that you get slightly higher interest, but there are restrictions on your ability to access it. But it's not too hard to turn it into checking accounts. And small dollar value time deposit, CD accounts. But for the sake of simplicity, in this example, it would be the saving accounts. So it would be our $7 of M1, plus the $2 of savings accounts right over here. So this is just to give you a picture. When someone talks about the money supply you really have to say, well, what are you talking about? The most typical one is that you're really talking about M1, because this is the stuff that's directly usable to facilitate transactions. Things like the ability to write a check, or dollar bills in someone's wallet. But they might be talking about base money, M0, narrow money, always of referring to the same thing, especially in the United States. Or they might be referring to something even broader. And there are broader definitions even than M2, although M3, they've stopped reporting about it. But M3 would have things that are a little bit further from being true money, from being a checking account. But they are already fairly liquid and so they'll include other types of assets. But the Fed has stopped reporting this in the recent past. So these are the ones that are typically referred to.