M1

What Is M1?

M1 is a narrowly defined measure of the money supply within an economy, representing the most liquid forms of money readily available for transactions. It is a key monetary aggregate used in monetary economics to gauge the immediate purchasing power held by the public. The components of M1 primarily include physical currency in circulation and highly liquid bank deposits. This measure provides insight into the short-term liquidity of an economy and is monitored by central bank authorities, such as the Federal Reserve in the United States, to understand current economic conditions.

History and Origin

The concept of measuring the money supply evolved as economists and policymakers sought to understand the financial landscape and its impact on the broader economy. In the United States, the Federal Reserve began systematically collecting monetary data and defining aggregates like M1 in the mid-20th century. Early definitions of M1 primarily included currency outside of banks and demand deposits (checking accounts). Over time, as financial innovations emerged, the definition of M1 has been subject to revisions by the Federal Reserve to reflect changes in how money is held and used. For instance, in 1980, the Fed introduced M1A and M1B, reflecting the inclusion of new account types like Negotiable Order of Withdrawal (NOW) and Automatic Transfer Service (ATS) accounts³¹. More recently, a significant redefinition occurred in May 2020, when the Federal Reserve Board announced that savings deposits would be included in M1, classifying them as "other liquid deposits" due to their increasing transactional utility²⁸, ²⁹, ³⁰. This adjustment aimed to better reflect the modern financial landscape where distinctions between transaction and non-transaction accounts have blurred²⁷.

Key Takeaways

• M1 represents the most liquid components of the money supply, including physical cash and easily accessible bank deposits.
• It serves as a crucial indicator for policymakers to assess the immediate transactional capacity and economic activity within an economy.
• The definition of M1 has evolved over time, with notable changes by the Federal Reserve to incorporate new types of liquid accounts.
• M1 is one of several monetary aggregates published by central banks, providing a snapshot of the economy's financial health.
• While M1 provides insights into short-term liquidity, its direct relationship with broader economic variables like inflation has varied over time, leading central banks to use a broader set of indicators for monetary policy.

Formula and Calculation

The calculation of M1 involves summing its core components. In the United States, M1 primarily comprises:

Where:

• $C$ = Currency in circulation (physical cash, including coins and Federal Reserve notes, held by the public outside of the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions).²⁶
• $DD$ = Demand deposits (balances in checking accounts at commercial banks, excluding those held by the U.S. government, foreign banks, and other depository institutions).²⁵
• $OLD$ = Other Liquid Deposits (comprising checkable deposits like NOW and ATS accounts, share draft accounts at credit unions, demand deposits at thrift institutions, and savings deposits, including money market accounts).²⁴

These components are typically reported on a seasonally adjusted basis by the Federal Reserve to remove regular seasonal fluctuations, providing a clearer view of underlying trends²³.

Interpreting the M1

Interpreting M1 data involves understanding what its movements suggest about the economy's immediate transactional capacity and spending potential. An increasing M1 generally indicates that more liquid funds are available for spending, which can be a signal of growing economic activity or increased public preference for holding readily accessible funds. Conversely, a shrinking M1 could suggest a reduction in immediate spending power or a shift of funds into less liquid assets.

Economists and policymakers analyze M1 in conjunction with other economic indicators, such as Gross Domestic Product (GDP), inflation rates, and interest rates, to gain a comprehensive understanding of the financial environment. For instance, a rapid increase in M1 might, under certain conditions, signal potential inflationary pressures if the supply of money grows faster than the economy's capacity to produce goods and services²². However, the relationship between M1 and these macroeconomic variables can be complex and has changed over time due to financial innovation and evolving consumer behavior.

Hypothetical Example

Imagine a small island economy, "Liquida," where the central bank monitors its money supply. In January, Liquida's M1 is calculated as follows:

• Physical currency held by residents: $50 million
• Balances in checking accounts: $120 million
• Balances in savings accounts (which are readily accessible for transactions): $80 million

Using the M1 formula:

Now, suppose in February, due to a new government stimulus package encouraging immediate spending, people withdraw $10 million from their less liquid time deposits and move it into their checking accounts, and another $5 million from certificates of deposit directly into savings deposits. The physical currency and existing checking/savings balances remain largely the same, except for this shift.

The change would be:

• Physical currency: $50 million (unchanged)
• Balances in checking accounts: $120 million + $10 million = $130 million
• Balances in savings accounts: $80 million + $5 million = $85 million

The new M1 for February would be:

This increase in M1 from $250 million to $265 million would suggest that the total amount of readily available money in Liquida has increased, potentially indicating a boost in short-term spending capacity and economic liquidity.

Practical Applications

M1 is a vital measure for various aspects of the economy, especially within the domain of monetary policy.

• Monetary Policy Guidance: Central banks, such as the Federal Reserve, use M1 as part of their comprehensive assessment of the money supply. While its role as a direct target for policy has diminished, M1 still provides insights into the current liquidity in the financial system and helps inform decisions related to interest rates and other tools.²¹
• Economic Analysis: Economists analyze M1 trends to understand short-term economic activity and consumer spending patterns. A rising M1 can indicate increased transactional capabilities, while a falling M1 might signal a slowdown.²⁰
• Inflationary Pressures: Although the relationship is not always straightforward, significant and sustained increases in M1 can, in some economic theories, be linked to potential inflation if not accompanied by a proportional increase in the production of goods and services¹⁹.
• Financial Stability: Monitoring M1 helps in assessing the stability of the financial system by gauging the availability of highly liquid funds within financial institutions.

The Federal Reserve regularly publishes data on M1 and other monetary aggregates in its H.6 statistical release, which is widely used by analysts and researchers to track these measures¹⁸.

Limitations and Criticisms

While M1 serves as a key monetary aggregate, it has faced several limitations and criticisms over time, particularly regarding its reliability as a sole indicator for monetary policy.

One significant criticism is its limited scope¹⁷. Until recently, M1 excluded savings deposits and other liquid assets that function similarly to checking accounts in terms of their accessibility for transactions¹⁶. The Federal Reserve's redefinition in May 2020 addressed this by including savings deposits, recognizing the blurred lines between transaction and non-transaction accounts¹⁴, ¹⁵. However, M1 still does not include less liquid assets that are part of broader money supply measures.

Another challenge is the volatility of M1 data and the impact of financial innovation¹², ¹³. The introduction of new financial products and services, along with shifts in consumer behavior (e.g., electronic payments, online banking), can alter the relationship between M1 and other economic variables like national income and prices¹⁰, ¹¹. For example, policymakers in the 1980s faced challenges in using M1 as a reliable guide due to deregulation and changes in how financial assets were held⁹. Initial M1 data releases can also contain significant errors, which are later revised, making real-time interpretation difficult for policymakers⁸.

Consequently, central banks, including the Federal Reserve, have generally moved away from a heavy reliance on M1 as a primary target for interest rates or monetary policy decisions, instead favoring a more eclectic approach that considers a wider array of economic indicators⁷.

M1 vs. M2

M1 and M2 are both measures of the money supply but differ in their scope of liquidity.

The main point of confusion often arises because the components of M1 are subsets of M2. Any change in M1 will directly affect M2, as M2 is defined as M1 plus additional assets. However, changes in the non-M1 components of M2 (such as shifts between savings accounts and small time deposits before the 2020 M1 redefinition) would affect M2 without necessarily impacting M1.

FAQs

How does M1 relate to the overall money supply?

M1 is the narrowest definition of the money supply, focusing on the most liquid assets. It is a subset of broader measures like M2 and M3, which include less liquid forms of money. Central banks track these different monetary aggregates to get a full picture of the funds available in an economy.

Why did the definition of M1 change in 2020?

The Federal Reserve changed the definition of M1 in May 2020 to include savings deposits as "other liquid deposits"⁴. This change was made because the operational distinction between checking and savings accounts had become less clear, with many savings accounts now offering features that allow for easy transfers and payments, making them functionally similar to traditional demand deposits², ³. This adjustment aimed to provide a more accurate reflection of the transactional money supply in the modern financial system.

Is M1 still important for monetary policy?

While M1's direct role as a primary target for monetary policy has diminished in recent decades due to its changing relationship with economic activity and inflation, it remains an important indicator. The Federal Reserve and other central banks continue to monitor M1, alongside M2 and other economic data, to assess market liquidity and inform their policy decisions¹.