M1_money_supply

What Is M1 Money Supply?

M1 money supply is the narrowest and most liquid measure of the total money in circulation within an economy, representing funds readily available for spending and transactions. It is a key metric within monetary economics, providing insights into the immediate purchasing power held by the public. This aggregate is primarily composed of physical currency in circulation and demand deposits. Policymakers and economists closely monitor M1 as part of broader efforts to understand and manage economic activity and financial stability.

History and Origin

The concept of measuring the money supply evolved alongside the development of modern financial systems. In the United States, the Federal Reserve began systematically collecting and publishing data on monetary aggregates, including M1, starting in the 1960s. During the 1970s and 1980s, these measures became particularly critical as economists studied the relationship between money growth and inflation. The composition and definition of M1 have been refined over time to reflect changes in how money is held and transacted. For instance, in May 2020, the Federal Reserve updated its definition of M1 to include other liquid deposits, such as savings accounts, recognizing their increased liquidity and transactional nature¹⁵. This adjustment significantly altered the reported value of M1 at that time.

Key Takeaways

• M1 money supply measures the most liquid forms of money in an economy.
• It includes physical currency in circulation and checkable deposits.
• The Federal Reserve regularly publishes M1 data as part of its Money Stock Measures¹⁴.
• While once a primary guide for monetary policy, M1's direct correlation with other economic variables has diminished over time.
• Changes in M1 can reflect shifts in consumer behavior, liquidity preferences, and broader economic sentiment.

Formula and Calculation

The M1 money supply is calculated as the sum of its core components:

Where:

• Currency in Circulation refers to physical banknotes and coins held by the public, excluding those in the vaults of the Federal Reserve and depository institutions.
• Demand Deposits are balances in checking accounts that can be withdrawn or transferred on demand, such as standard checking accounts.
• Other Liquid Deposits include savings deposits, traveler's checks (of non-bank issuers), and other checkable deposits like NOW (Negotiable Order of Withdrawal) accounts.

This formula aggregates the most readily available forms of money, highlighting immediate purchasing power.

Interpreting the M1 Money Supply

Interpreting the M1 money supply involves understanding its components and how changes might indicate shifts in the economy. An increase in M1 generally suggests that more money is available for immediate transactions, which could signal growing consumer spending and overall economic growth. Conversely, a decrease might indicate a slowdown in economic activity as individuals and businesses hold less readily available cash. Central banks and financial analysts observe M1 trends to gauge market liquidity and the potential for shifts in demand, which can influence various financial markets¹³. However, the relationship between M1 and economic variables like inflation and Gross Domestic Product (GDP) has become less straightforward than in previous decades.

Hypothetical Example

Imagine a small island nation called "Atlantis" with a simplified financial system. The central bank of Atlantis reports its M1 money supply.

Currently, the M1 components are:

• Physical currency held by the public: $500 million
• Demand deposits in commercial banks: $1.2 billion
• Other liquid deposits (savings accounts, etc.): $800 million

Using the M1 formula:

If, in the following quarter, the central bank implements policies that encourage more bank lending, and as a result, demand deposits increase to $1.5 billion, while currency and other liquid deposits remain constant, the new M1 would be:

This increase in M1 might suggest an expansion in the money supply, indicating more funds available for transactions within Atlantis's economy.

Practical Applications

The M1 money supply, as a fundamental economic indicator, has several practical applications:

• Monetary Policy Analysis: Central banks, like the Federal Reserve, collect and publish M1 data as part of their broader analysis of the money stock. While its direct role in guiding real-time monetary policy has evolved, it remains a component in understanding the overall monetary landscape and serves as a basis for other money supply measures¹¹, ¹².
• Market Liquidity Assessment: Analysts in financial markets monitor M1 data to assess the level of immediate liquidity in the economy. An expanding M1 can suggest increased funds available for investment, potentially supporting market rallies, while a contraction might imply tighter financial conditions¹⁰.
• Economic Forecasting: Though its predictive power has been debated, M1, along with other monetary aggregates, provides context for forecasting economic trends. It can offer clues about consumer spending habits and the willingness of individuals and businesses to hold money in highly liquid forms⁹.
• International Comparisons: Organizations such as the International Monetary Fund (IMF) collect and standardize money supply data, including M1, from various countries. This allows for cross-country comparisons and helps in understanding global monetary conditions and the transmission of monetary policy internationally⁷, ⁸.

Limitations and Criticisms

Despite its role as a key monetary aggregate, M1 money supply faces several limitations and criticisms:

• Limited Scope: Critics argue that M1, by focusing solely on the most liquid assets, provides an incomplete picture of the overall money supply. It historically excluded assets like savings deposits, which, over time, became increasingly liquid and functionally similar to checking accounts, prompting the May 2020 redefinition by the Federal Reserve⁶.
• Volatility: M1 can be highly volatile, experiencing significant fluctuations that may not always reflect underlying economic realities. These swings can make it challenging to use M1 as a consistently reliable indicator for monetary policy or long-term economic trends⁵.
• Changing Definitions: The evolving nature of financial instruments and payment methods necessitates periodic redefinitions of monetary aggregates. While necessary, these changes can complicate historical comparisons and the consistency of analysis over long periods⁴.
• Diminished Correlation: Economists and policymakers acknowledge that the once-strong correlation between M1 and key economic variables, such as inflation and GDP, has weakened in recent decades. This has led many central banks to rely on a broader array of economic data and indicators, including interest rates, when formulating fiscal policy and monetary strategy³. The relationship between monetary aggregates and the economy is complex and can be influenced by factors like the money multiplier and financial innovation.

M1 Money Supply vs. M2 Money Supply

The primary distinction between M1 money supply and M2 money supply lies in their breadth and the liquidity of their components. M1 represents the most liquid forms of money, including physical currency in circulation and demand deposits, which are immediately available for transactions. M2 is a broader measure that encompasses all of M1 plus "near money" instruments that are slightly less liquid but can still be converted to cash relatively easily.

Specifically, M2 adds:

• Small-denomination time deposits (certificates of deposit below a certain threshold)
• Savings deposits (now included in M1, but historically a key component distinguishing M2)
• Retail money market mutual funds

The key difference is that M1 captures assets used for everyday spending, while M2 includes M1 components along with financial assets that serve as short-term savings vehicles. M2 is generally considered a more stable measure of the money supply compared to the more volatile M1 because it includes a wider range of assets.

FAQs

Q: Why is M1 called the "narrowest" measure of money supply?
A: M1 is considered the narrowest because it only includes the most liquid forms of money—assets that can be directly used for transactions without any conversion. These are physical currency and various types of checking accounts.

Q: Does M1 include credit cards?
A: No, M1 does not include credit cards. Credit cards represent a line of credit or a loan, not a form of money held by the individual. When you use a credit card, you are borrowing money that you will need to repay later, rather than spending existing money from your balance sheet.

Q: How does the Federal Reserve measure M1?
A: The Federal Reserve collects data from commercial banks and other depository institutions to compile its weekly and monthly H.6 Money Stock Measures release. This release details the amounts of currency in circulation, demand deposits, and other liquid deposits to arrive at the M1 total.
¹, ²
Q: Is M1 still important for economic analysis?
A: While M1's direct correlation with inflation and GDP has changed, it remains relevant as a measure of immediate liquidity and purchasing power. Central banks and analysts still consider M1 data alongside other economic indicators to gain a comprehensive understanding of the monetary landscape and broader economic activity.