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M0, M1, M2

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Author: Kate Eskra
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This lesson covers the M0, M1, M2

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Tutorial

Source: Image of bank notes, public domain, http://en.wikipedia.org/wiki/File:Billets_de_5000.jpg, Image of check, creative commons, http://en.wikipedia.org/wiki/File:Sweet_success.jpg

Video Transcription

Hi. Welcome to macroeconomics. This is Kate. This tutorial is on M0, M1, and M2. As always, my key terms are in red, and any examples are in green. In this tutorial, we'll talk about how money is anything that serves as a medium of exchange, a store of value, and a unit of account. Those are the three functions of money.

We'll also discuss how we can classify money according to how liquid is. And that's where the title of the tutorial comes from. We classify them as M0, M1, and M2. Finally, we'll discuss how the FOMC, or Federal Open Market Committee, is the organization in our country who manages and makes decisions about the supply of money.

OK. So as a reminder, there are three functions of money. Really, money is anything that serves as, first of all, a medium of exchange. A medium of exchange helps us to get the things that we want. So when we use our debit card, or cash, or a check, or a credit card, to buy something, it's acting as a medium of exchange. Money also has to act as a store of value, a way to store our dollars that we're not spending right now. So the fact we can save them and they retain value makes it a good store of value.

And then finally, money serves as a unit of account. Something that helps in record keeping and in financial transactions. Helps us to compare values of things. The fact that we can cite things in dollars helps us to compare something that is \$10 versus something that is \$5. So that's a unit of account.

So again, when most people think of what money is, we tend to think of bills and coins and things like that. But if money really is anything that fits those three functions and allows us to get what we want, isn't it also checks and debit cards? What else could it possibly be? Well, the thing is, depending on how easy or difficult it is to spend a certain type of money, we can then classify it.

So some forms of money like cash-- if I have cash in my wallet right now, that's really easy. I can go out and spend it right this second. But the money that I have in my savings account, well, it's not difficult for me to transfer that into my checking account and then take the money out at an ATM to get the cash. It involves a few more steps to be able to spend it.

This concept is known as liquidity. So things like cash that are easy to go out and spend right now are very liquid. Things that involve a couple more steps, like money in my savings account, are not as liquid. So that is the concept behind this entire tutorial.

So M0 is the narrowest definition of money. And this is going to include only the stock of physical currency. So this is the most liquid we can get. Since it's the narrowest way of defining what money is, it's really just all physical or actual cash held by people right now that's out there. So this, because almost everyone accepts cash as a form of payments.

I don't know about you though, I very rarely have much cash on me. Because if I do have cash on me, I've already spent it. I needed cash to pay my neighbor for Girl Scout cookies. She came the other day, and I was rooting around my house. I knew I had the \$12 somewhere. But cash is the most liquid form of paying. I certainly could have written her a check, but I wanted to give her cash to make it easy.

M1 is going to include M0. So this is an inclusive category. But now we're going to include demand deposits. Checking account balances are known as demand accounts, or demand deposits. Because we can demand the money at any time. We can write a check on them at any time. So M1 is these demand or checking account balances plus our M0, or actual physical cash. So if we include money that we can really easily spend, M1 includes our checking accounts. So it's not actual physical cash, but you can go swipe your debit card almost everywhere right now and immediately purchase something.

So like I said, I couldn't use a debit card to buy my Girl Scout cookies, but I probably could have written her a check. And that check would've come out of my checking account. So all of those abilities to use on our checking accounts, that is M1, still pretty liquid.

M2 gets a little bit further. So this is the least liquid of something we're going to talk about today. This is-- so it's M1 plus M0. So M0 was our physical currency. M1 were our demand deposits. But now we're going to go to the least liquid thing. And that's what we call time deposits. So this is the broadest way of defining what money is. And this is including all the ways that you're holding money that you just can't immediately pay for something right now. So it's money in my savings accounts. Some people have money market mutual funds. This is what we mean by a time account. I think of it like it's going to take some time to be able to use it or convert it to cash.

And usually, you have to hold these things in an account for a certain amount of time. After Christmas, I needed to transfer some money from my savings into my checking to pay my credit card bills. So I was taking money from my M2 and putting it into M1 so that I could actually spend it. Because it involved additional steps, that money's not quite as liquid.

So it's our FOMC, or Federal Open Market Committee, that is part of our Federal Reserve System. And they meet several times a year, eight times a year, to manage our nation's money supply. So when we talk about, in future tutorials, managing our nation's money supply, we want you to think about the three components of the money supply-- the really liquid money of M0, the still pretty liquid money of M1, and the less liquid money of M2.

Think about how the things that they do impact each of those parts of our money supply. The tools that they have to control each of these components of our money supply are the reserve requirement, open market operations, the fed funds market, and the discount rate. So each of these will be a subject of a future tutorial. But very quickly, the reserve requirement is the amount of money that banks have to hold on reserve. And the FOMC can change that, making it either easier or more difficult for banks to lend out money.

Open market operations are the buying and selling of treasury securities. So like bonds. So when they engage in buying bonds, they're going to put money in circulation. When they engage in selling bonds, they're taking money out of circulation. The fed funds market and the discount rate are rates that banks have to pay to borrow. Here, they're borrowing from each other. And the discount rate is when they're borrowing from the Fed.

So if they're targeting these rates and raising it or lowering it, it's making it, again, either easier or more difficult for the banks to get their hands on money and then loan it out. So again, think about how all of these tools, as we talk about them in other tutorials, will impact these components-- M0, M1, and M2 of our money supply.

So I reminded you in this tutorial that money has three functions, and it serves as a medium of exchange, a store of value, and a unit of account. And we looked at how we can classify money according to how liquid it is, with M0 being the most liquid, and M2 being the least liquid.

Then finally, we just looked at how our Federal Open Market Committee is the organization in our country who manages and makes decisions about the supply of money through various tools.

Thanks so much for listening. Have a great day.

Terms to Know
M0

The narrowest definition of money, includes only the stock of physical currency.

M1

Includes demand deposits (checking account balances) + M0 (stock of physical currency).

M2

Time deposits + M1 (demand deposits + stock of physical currency).