Introduction
Understanding and knowing how to apply the money supply is key to your AP® Macroeconomics review. Economists use different terms for different measures of the money supply; specifically, they will refer to M1, M2, and M3. So, what are M1, M2, and M3, and how does it apply to the supply of money? In this crash course review, you’ll find out exactly what M1, M2, and M3 are, and you’ll learn how they apply to concepts that you’re used to, such as currency or checkable deposits.
What are M1, M2, and M3?
To understand what M1, M2, and M3 are, first you’ll need to know some crucial definitions. How much money is in the economy at any given time? What do you usually think about when you think about money? Other than that, we’d all like some more of it! Well, when any of us think of money, we surely think of a country’s currency, which is printed by the central bank. In the United States, our central bank is called the Federal Reserve. However, many other things can also be thought of as money! We will see that what is thought of as money depends on what happens after that cash has been printed and left the central bank!
Before we delve into all the ways we can think about money so that we can understand M1, M2, and M3, we should introduce the concept of liquidity. Think of liquidity simply as how easy it is to access money from an asset, or from something of value you own. For instance, currency is obviously very liquid because you can use it to buy things right away. However, think of owning the stock of a company. This is much less liquid; you have to sell the stock before you can use the money. This means that first, you have to find someone willing to buy the asset off of you, and may even pay a fee when you do so, and only then will you have some cash on hand to buy what you want!
Keeping liquidity in mind, consider putting your money into a bank. If you put your cash into a checking account at a bank, you’ll be able to write checks against that money. This means that your checkable deposit is basically just as liquid as the cash you were holding. However, what if you put your money into a non-checkable savings account? While some savings accounts these days do act a bit like checking accounts, most do put some sort of limit on how much or how often you can withdraw money from that account. For simplicity, though, here you can just think of non-checkable savings accounts as being ones from which you can’t easily withdraw or write a check. It is these types of varying liquidities that will matter for how we describe M1, M2, and M3!
With this in mind, let’s think about checkable deposits. When you make a checkable deposit at a bank, the bank is allowed to loan out some of that currency while keeping some of it in the bank as a reserve. In doing so, that currency will end up in the hands of someone else. Then, they may take that currency and put it into their bank as a checkable deposit. Their bank also has the option to loan some of the currency out, and this continues on and on and on. However, notice that both you and the other person can each still write checks against these deposits. Both of you can easily go to the store and buy something by writing a check or, as is more common now, swiping your debit card. This makes these checkable deposits basically as liquid as currency even if the currency may have been loaned out and currently resides at some other bank or in some other person’s wallet. Now, we’re ready to understand what M1 is. M1 consists of the currency that is currently out there in people’s wallets plus how many checkable deposits we all have!
Next, we can use this concept of liquidity to figure out what M2 is. M2 is a broader definition of money, consisting of M1 plus things that are not too much of a hassle to convert to currency. Thinking back to our non-checkable savings account, we may not be able to write checks against it, but we will have some leeway about when we can withdraw the money and simply have the currency again. So, M2 consists of M1 plus things that we think of as near-monies, things like savings accounts, money mutual funds, and small time deposits that can be relatively quickly turned into currency.
The broadest measure of the money supply is M3. M3 includes what we already had in M2 plus a few items that are less liquid than M2, but that are still liquid enough that we can think of them as being part of the money supply. For instance, M3 also consists of large time deposits. Time deposits are deposits at a bank that have a set date at which you can withdraw the money. Large time deposits will be less liquid than small time deposits, and hence, will be included in M3 rather than M2.
Practice Question
You now understand what M1, M2, and M3 are, but what can you expect to show up on an AP® Macroeconomics exam? While M1, M2, and M3 may not be asked specifically on a free response question, in the course of your studies and on various free response questions, you may run into something called the money multiplier. This post isn’t on the money multiplier, but when you move on in your studies, you’ll see that this simple example on M1, M2, and M3 will also help you when you work through money multiplier problems.
For our example, let’s say that the Federal Reserve has decided to print $100. We will describe the path that this $100 takes, and then decide what M1, M2, and M3 are in our example at the end! For the sake of simplicity, let’s say that the Fed puts the currency into the economy by buying an asset—for instance, a government bond—from an individual. This individual decides to deposit all $100 in his bank, putting $50 in his checking account and $50 in a large-time deposit. Assume that banks are required to hold 50 percent reserves. This means that with $50 in their checkable accounts, they can only loan out $25 of that. However, the bank is able to lend out the entirety of the $50, since it is harder to withdraw the large time deposit. The $25 that is loaned out ends up with someone who holds onto $10 in his or her pocket and puts the other $15 in a standard non-checkable savings account. This $15 is then loaned out to a company that buys widgets from an individual, who then keeps the $15 in his or her pocket. What about that $50 large-time deposit? It is loaned out to an individual and eventually $25 is put into a mutual fund and $25 is kept in his or her pocket. The $25 in the mutual fund is invested in a company that, as luck would have it, also buys widgets from the widget seller. The widget seller, being obsessed with cash itself, also holds onto this money.
OK, that was a lot of money movement in our simple economy! Let’s take a step back and try to find out where it all ended up! What are M1, M2, and M3? We know M1 is currency on hand plus checkable deposits. Let’s look back through our example and see how much currency is left. Here, it helps to write it all out on paper so you can visually see where the money has moved. We notice that the widget seller has $25 plus $15 for $40 in his or her pocket. The person who put money in a savings account is also holding $10 in his or her pocket. Also, the individual that put money in a mutual fund held $25 in his or her pocket. This means that the currency floating around in the economy is $40 + $10 + $25 = $75. Now, what about checkable deposits? Only one person in our example has a checkable deposit, and it’s the first individual who has the ability to write up to $50 in checks. This means that M1, being currency plus checkable deposits, is $75 + $50 = $125.
What about broader money? We know that M2 also includes some slightly less liquid items, like savings accounts and mutual funds. In this example, we see that $25 has been placed in a mutual fund and $15 was in a standard non-checkable savings account. So, our measure of M2 is M1 + $25 + $15 for $165.
Finally, the broadest measure is M3 and includes M2 plus the slightly less liquid large time deposit. The only large time deposit in our economy was from the first individual and was worth $50. So the broadest measure of the money supply in our economy is M3, which is M2 + $50 for $215.
Conclusion
M1, M2, and M3 are different measures of the money supply. They are vital to your AP® Macroeconomics review, as the money supply will take center stage in parts of your course. Here, you’ve learned how to distinguish what is M1, M2, or M3. Can you think of any types of money you think we missed, and do you think they would be part of M1, M2, or M3
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