The purchasing power of money and the cost of credit (interest rates) are determined by supply and demand in much the same manner that prices are determined for shoe polish or fudge. In the remainder of this chapter, we describe the assets that make up the U.S. money supply and examine the role of financial institutions in determining the money supply. This sets the stage for analyzing how the demand and supply of money jointly determine the price level, the rate of inflation, and the rate of interest.
The functions of money hint at operational definitions of the money supply: Money is a medium of exchange, a measure of value, a store of value, and a standard of deferred payment. Be aware, however, that just as no measure of unemployment precisely fits the economic concept of unemployment, no measure of the money supply conforms perfectly to money as a concept.
Narrowly Defined Money (M1)
Currency (coins and paper bills) is the most easily identified component of the money supply because it may be used (a) for virtually all transactions, (b) to price goods and services, and (c) as an asset. Demand deposits are the other major assets that perform all monetary functions.
Demand deposits are funds in checking accounts in commercial banks, savings and loans, or credit unions.
These funds are legally required to be available on demand, normally by check or through automatic teller (ATM) machines. Together, currency and demand deposits (plus such minor accounts as travelers' checks) are the narrowly defined money supply known as M1:
M1 = currency + demand deposits in financial institutions
We do need to qualify this a bit. Only currency held by the nonbanking public is included in the money supply. We would be "double counting" if both the currency you deposit in your checking account and your demand deposits were counted. Deposits of the federal government are also ignored because, via the Federal Reserve System, it can print money at will. Moreover, because federal spending is not limited by money the government has on hand, inclusion of federal deposits would not aid us in predicting Aggregate Expenditures when using money supply data.
"But," you might object, "credit cards can pay for almost anything. And how about my savings account?" Sadly, a credit card is simply an easy way into debt; credit cards are not stores of value, so they are not money. Standard savings accounts also fail the test because spending savings account "money" requires prior conversion into cash or a demand deposit. Try presenting a savings passbook to pay for your next meal out---you will be washing dishes in no time!
Banks and such "thrift institutions" as savings-and-loan associations (S&Ls) and credit unions now offer some checking account services (e.g., NOW accounts) that pay interest to depositors. Recent changes in federal law have transformed most "thrifts" into banks and some of their deposits into checking accounts. Throughout this book, we usually mean all banklike
institutions when we say "banks" and include all checkable accounts when we refer to "checks."
Demand deposits and currency are the only major assets that are both mediums of exchange and widely accepted as money. We admit that parking meters do not accept checks, that few cab drivers will change a $100 bill for a $3 fare, and that few banks would settle a $100,000 mortgage if you rolled up with a dump truck filled with 10 million loose pennies. But checks and currency can be used for most transactions much more easily than can other assets.
Near-Money (M2, M3, and L)
Some economists do count certain highly liquid assets, such as savings accounts (time deposits), as parts of the money supply. The economists who use broader definitions of the money supply than M1 believe that people's spending levels are more predictable by monetary data if we include the liquid assets that are highly interchangeable with currency and demand deposits.
One broader definition is M2, which adds such assets as noninstitutional money market funds and savings in commercial banks and thrift institutions to M1:
M2 = M1 + miscellaneous short-term time deposits
= currency + demand deposits + small time deposits
Other monetary theorists expand the definition of money to M3, which includes such items as large time deposits and institutional money market mutual funds:
M3 = M2 + institutional money market mutual funds + large time deposits
There is one even broader official definition of the money supply, L, which adds such liquid assets as short-term government bonds and commercial paper to M3. Exactly which definition of the money supply is most useful depends on how it will be used. Throughout this book, when we say money, we mean currency plus any funds available by writing checks (M1). How various measures of the money supply have grown is shown in Figure 1.
FIGURE 1 Measures of the Money Supply
The money supply is composed of various aggregates, depending on how broadly you define it. M1 is the narrowest definition, while L is the most expansive.
Source: Economic Report of the President, 1994, Federal Reserve Bulletin, 1994
All these measures of the money supply have grown substantially over the years, as have our GDP and the cost of living (CPI). How should these positive correlations be interpreted? Does monetary growth cause inflation? Does it cause GDP to grow, or does economic growth cause the money supply to expand? How does monetary growth affect the total output of goods, and vice versa? These questions are at the heart of a continuing controversy between monetarists and Keynesians, and they are examined in the next few chapters.