Money supply measures are the different ways we have in the U.S. for counting the money supply. There are three common money supply measures in use today. Each of the three looks at the money supply from a slightly different standpoint. In years gone by it was thought that there was or should be a perfect one to one ratio between these three numbers and the rates of inflation. However, time has shown that this relationship has broken down, and these money supply numbers have lost some of their luster as a result with the money watchers and those who participate in the broader financial markets.
The terms M1, M2 and M3 refer to what are known as the monetary aggregates. Even though that perfect relationship between these numbers and the rate of inflation has somehow broken down through the years, M1, M2 and M3 still have some importance in the domestic financial arena. Strong growth in the money supply denotes possible sharp increases in inflation as money inflates aggregate demand. Here we present brief explanations for all three monetary aggregates.
M1 is defined denotatively as the sum of the legal tender that is held outside of banks, travelers' checks, and checking accounts, less the amount of money in the Federal Reserve float.
M2 is all of M1, plus the sum of savings deposits including money market accounts against which no checks can be written, time deposits under $100,000, and retirement accounts.
M3 is M2 plus large time deposits (deposits larger than $100,000), deposits in Euros, U.S. dollars held at offices of domestic banks on foreign soil, and lending institution money market accounts.
U.S. economists define the money supply as the total amount of money available within a given economy. In this definition, money is thought of as the amount of currency that's actually in circulation plus the amount on deposit at domestic financial institutions. At these institutions money is often held virtually, since no bank literally holds every dollar of the money on deposit. (As a side note, money is not considered to be in circulation any longer once it is on deposit.)
As mentioned previously, there are three monetary aggregates in the United States. Each one is separated according to its level of liquidity. The more liquid a financial resource is, the quicker it can be converted into cash. Of course, this means that good old greenbacks have the highest liquidity of all. M1, then, is the aggregate considered the most liquid. Aside from cash, checks are the most liquid of all aggregates, and products like annuities tend to be very illiquid. Someone with a check written against a checking account at a local bank can simply walk into that bank with valid ID and cash the check right there at the counter (provided, of course, that the checking account against which the check was written has sufficient funds to cover the draft).
M2 does include M1, but also includes less liquid assets like smaller deposits, money market funds, and retirement accounts. It is less liquid than M1 because it takes more time and more effort to convert these aggregates into cash. M3 aggregates, of course, are even less liquid; including huge deposits that would be a hassle to withdraw, money held abroad, and pension fund deposits.
M1, M2, and M3 do not include the money created and available at the Federal Reserve. The amount of money at the Fed is supposed to approximate the amount in circulation. Getting hard numbers on the total money supply is next to impossible, but these numbers get us close.
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