M1 Money Supply: Definition, Calculation, Impact on the Economy

Understanding money is as good as understanding liquidity and how it works. While cash is undoubtedly a form of money, the same cannot be said for checks and credit cards. The concept of money is not limited to a singular definition, as economists typically define money in broader terms that consider its liquidity.

Liquidity describes the ease with which a financial asset can be utilized to purchase goods or services. For instance, cash is highly liquid. There are two ways to define money relating to its liquidity, which include M1 and M2 money supply.

The M1 money supply comprises highly liquid forms of money, including physical cash, demand deposits, and traveler’s checks. On the other hand, the M2 money supply encompasses less liquid forms of money, such as savings and time deposits, certificates of deposit, and money market funds, in addition to the components of M1.

Money Supply Defined

The money supply is the combined value of all liquid assets, including cash, in a country’s economy on a specific date. It encompasses all physical currency in circulation and bank deposits that can be easily converted to cash.

The issuance of paper currency and coins is typically the responsibility of a country’s central bank or treasury, or a combination of both. To ensure economic stability, regulatory bodies monitor and adjust the available money supply through changes in policy and regulations.

Basically, tracking the money supply over time is a vital component of analyzing the overall economic health, identifying any vulnerabilities, and formulating corrective policies.

Money Supply and Economy

The relationship between the money supply and the economy cannot be overemphasized. Expanding the money supply typically leads to a decrease in interest rates, which stimulates investment and increases consumer spending, resulting in businesses buying more raw materials and increasing production, consequently raising demand for labour.

Conversely, a decrease or slower growth rate of the money supply can lead to banks lending less, businesses postponing new projects, and reduced consumer demand for mortgages and loans.

The money supply has long been considered as a crucial factor in driving economic performance and business cycles. Various macroeconomic schools of thought that emphasize the role of the money supply include Irving Fisher’s Quantity Theory of Money, Monetarism, and Austrian Business Cycle Theory.

Examining the history of measuring the money supply has revealed correlations between the money supply, inflation, and price levels.

M1 Money Supply Explained

M1 money supply is a narrow measure of the money supply that includes all physical currency, such as coins and paper money, and the most liquid forms of money, such as checking account deposits and traveller’s checks.

M1 is one of several measures of the money supply used by economists and policymakers to understand the health of an economy. M1 is composed of the following:

• Physical currency. This includes all coins and paper money that is in circulation.
• Demand deposits. This refers to checking accounts and other accounts that allow account holders to withdraw money at any time without penalty. These accounts are also known as transaction accounts, and they are the most commonly used types of accounts for everyday spending.
• Traveller’s checks. These are prepaid checks that can be used like cash and are often used by people travelling overseas.

However, M1 does not include other forms of money that are less liquid, such as savings accounts and certificates of deposit (CDs), which require some notice or penalty to withdraw funds.

The basic intention behind the government’s decision to deliberately adjust the money supply is to affect the wider economy, as was done during the COVID-19 pandemic. In response to the crisis, governments boosted the M1 money supply to facilitate access to capital, support employment, and encourage business activity.

Central banks have various methods to increase the M1 money supply, such as increasing the circulation of physical currency, lending money to banks, or buying securities on the open market. Conversely, in the wake of COVID-19, central banks scaled back these measures to combat inflation and stabilize the economy.

Consumer and business spending also has an impact on the M1 money supply. As more money is spent, there is a higher demand for local currency. Consequently, using checks, debit cards, or credit cards increases the M1 money supply.

Calculating M1

The M1 money supply comprises the currency in circulation outside of the Federal Reserve banks and depository institutions, which includes Federal Reserve notes, commonly known as bills or paper money, and coins. Among these, paper money is the primary constituent of a country’s monetary system.

M1 is the most easily accessible segment of the money supply and includes the monetary base. The equation for calculating M1 is as follows: M1 = currency and coins in circulation + checkable deposits + traveller’s checks.

M1 vs M2 vs M3

M3 is the broadest measure of the money supply, encompassing all components of M1 and M2, as well as various forms of savings deposits, money market deposits, time deposits below $100,000, and institutional money market funds. It provides the most extensive view of the money supply compared to the other categories, as it includes a broader range of savings and investments that can be easily converted into cash.

M1 comprises the most liquid types of money in the economy, including physical currency, traveller’s checks, demand deposits, and other checkable deposits such as checking accounts. M2 expands upon M1 and includes “near money,” such as savings deposits, money market securities, and other time deposits that are less liquid and not as readily exchangeable as the components of M1.

While many elements of M2 can still be quickly converted into cash or checking deposits, they are not as instantaneous as the components of M1. Each category of the money supply has a slightly different definition of “cash” or liquid assets, but together they provide a comprehensive overview of the amount and accessibility of money in an economy.

Conclusion

Deducing on all that has been examined about the M1 money supply, it is correct to say it is the sum of currency, demand deposits, and other liquid deposits, which are typically seasonally adjusted. It comprises the most liquid assets compared to other measures of the money supply.

Meanwhile, inflation is closely linked to the money supply, and the Federal Reserve uses fiscal and monetary policies to manage the money supply and impact the economy.