The U.S. Money Supplies

What is money? In previous videos, we've taken the ordinary meaning of money for granted. But now we want to get a better understanding of money, banking, and central banking. And to do that, we need to be more precise about what money is and how we measure the supply of money. Economists typically define money as a widely accepted means of payment. Basically, money is anything that can be easily used to buy goods and services.

Now it's clear from this definition that currency -- paper bills and coins -- they're definitely money. Most of your payments, however, are probably made by writing a check or using a debit card -- both of which transfer funds from your bank account to the seller's bank account. Checking accounts, therefore, are also considered to be money. What about savings accounts? Well, now it gets a little bit tricky. Technically, you can't use the funds in a savings account to buy goods and services directly. But in practice, it's just so easy to move funds from a savings account to a checking account that we often also define savings accounts to be money.

For the same reasons, we often also define funds in a money market mutual fund to be money. What about jewelry? Is jewelry money? What about a watch or a comic book? Comic books aren't a widely used means of payment, but you could sell a comic book in your local pawn shop and use the proceeds to buy goods and services. So, is a comic book money? Probably not. Unlike moving funds from a savings account to a checking account, selling a comic book -- it takes quite a bit of work, and you never know exactly how much you're going to get. So, we don't consider comic books to be money.

The basic idea, then, is this: we count as money any asset that's a widely used means of payment or any asset that can be easily converted into a widely used means of payment with little loss in value. What is and isn't money, however -- it's not written in stone. There could be judgement calls. As a result, economists have defined several different measures of the supply of money. The most important of these are the monetary base and the cleverly named "M1" and "M2." The monetary base is defined as currency plus reserve deposits -- deposits held by banks and other institutions in their accounts at the central bank, the Federal Reserve.

You may not have heard of reserve deposits, but they're basically the checking accounts that banks use to pay one another. Since so many payments require that funds move from bank to bank, reserve deposits are a very important part of the financial system. M1 is defined as currency plus checkable deposits. M2 includes M1 plus savings deposits, money market mutual funds, and small-time deposits.

Now, there are other definitions of the money supply, but these are the ones which are most commonly used. The monetary base is important because as we'll see in future videos, the Fed has the most direct control over the monetary base. However, in order to have profound effects on aggregate demand and the economy, the Fed must also influence the bigger definitions -- M1 and M2. And in the next few videos, we'll learn about the tools that the Fed uses to try to control the money supply and aggregate demand. But first, we need to understand more about how banks can also influence the supply of money through fractional reserve banking and the money multiplier.