Loans and the Money Supply: M1 and M2

The money supply is a key economic indicator that measures the amount of money in circulation in an economy. It is a crucial factor in determining the overall health of an economy and is closely monitored by central banks and policymakers. Economists use two primary measures of the money supply: M1 and M2. This article will examine the differences between M1 and M2, explain why loans are not included in either measure, and cite relevant sources to support the discussion.

M1 and M2: Definitions and Components

M1 is the narrower of the two measures and includes the most liquid forms of money. It consists of:

• Cash: Physical currency in circulation, including coins and banknotes.
• Checkable (Demand) Deposits: Funds held in checking accounts that can be easily accessed and used for transactions.
• Traveler’s Checks: Prepaid checks that can be used to make purchases or obtain cash.

M2 is a broader measure that includes everything in M1 plus some less liquid assets. These include:

• Savings Deposits: Funds held in savings accounts that may have some restrictions on access or withdrawal.
• Time Deposits: Funds deposited for a fixed period of time, typically with a higher interest rate.
• Certificates of Deposit (CDs): Similar to time deposits but with a specific maturity date.
• Money Market Funds: Funds invested in short-term, highly liquid securities.

Loans and the Money Supply

Loans are not included in either M1 or M2. This is because loans represent a liability for the borrower and an asset for the lender. When a loan is made, the lender creates a new deposit in the borrower’s account. This increases the money supply by the amount of the loan. However, the loan is also recorded as a liability on the lender’s balance sheet, which offsets the increase in the money supply. As a result, loans do not have a net impact on the money supply.

Conclusion

M1 and M2 are two important measures of the money supply that provide insights into the liquidity and overall health of an economy. Loans, on the other hand, are not included in either measure because they represent a liability for the borrower and an asset for the lender, resulting in no net impact on the money supply.

References

• Measuring Money: Currency, M1, and M2 | Macroeconomics (https://courses.lumenlearning.com/wm-macroeconomics/chapter/measuring-money-currency-m1-and-m2/)
• Money Supply Definition: Types and How It Affects the Economy (https://www.investopedia.com/terms/m/moneysupply.asp)
• Are bank reserves part of M1 or only part of M2, and why? (https://economics.stackexchange.com/questions/6616/are-bank-reserves-part-of-m1-or-only-part-of-m2-and-why)

FAQs

1. What is the difference between M1 and M2?

M1 is a narrower measure of the money supply that includes the most liquid forms of money, such as cash, checkable deposits, and traveler’s checks. M2 is a broader measure that includes everything in M1 plus some less liquid assets, such as savings deposits, time deposits, certificates of deposit, and money market funds.

2. Why are loans not included in M1 or M2?

Loans are not included in either M1 or M2 because they represent a liability for the borrower and an asset for the lender. When a loan is made, the lender creates a new deposit in the borrower’s account, which increases the money supply. However, the loan is also recorded as a liability on the lender’s balance sheet, which offsets the increase in the money supply.

3. What are some examples of M1?

Examples of M1 include physical currency (coins and banknotes), checkable (demand) deposits, and traveler’s checks.

4. What are some examples of M2?

Examples of M2 include savings deposits, time deposits, certificates of deposit (CDs), and money market funds.

5. How does the central bank control the money supply?

The central bank controls the money supply through various monetary policy tools, such as adjusting interest rates, conducting open market operations, and setting reserve requirements for banks.

6. What is the relationship between the money supply and inflation?

There is a positive relationship between the money supply and inflation. When the money supply increases rapidly, it can lead to higher prices and inflation.

7. What is the relationship between the money supply and economic growth?

The money supply can impact economic growth. An appropriate level of money supply can facilitate economic growth by providing liquidity and enabling businesses and individuals to access financing. However, excessive money supply growth can lead to inflation and hinder economic stability.

8. How do economists use M1 and M2 to analyze the economy?

Economists use M1 and M2 to analyze the liquidity, health, and stability of the economy. Changes in M1 and M2 can provide insights into consumer spending, investment patterns, and overall economic activity.