Money Supply: M0, M1, and M2 - Economics Video Lecture

What I want to explore
in this video is
the different ways of
measuring the amount of money
we have in circulation.
So we're going to start
things with our Central
Bank in the US.
This would be the
US Federal Reserve.
And let's say that
they print $4.
And we're going to focus, just
for visualization purposes,
on that they're
doing it physically.
They could also do
it electronically.
But we're just going to
focus on the physical.
And the way that they
get this into circulation
is it they'll take
these $4 and they'll
go buy securities in the
open market, normally
very safe and very
liquid securities.
Liquid means it's very
easy to buy and sell
those securities in
large quantities.
For example,
government treasuries
is a liquid security,
or liquid asset.
PEZ dispensers would
not be a liquid asset.
If I bought a billion
dollars worth of PEZ
dispensers it would be very
hard for me to sell-- one
it would be very hard for me
to buy a billion dollars worth.
And it would be even
probably even harder
for me to sell a billion dollars
worth in any short or medium
timeframe.
So the Central Bank goes out,
and let's say they go and buy
one liquid security for $4.
So this is a security
right over here.
And the person that they
bought the security from
decides to deposit it in a bank.
They could either directly
deposit it in a bank
or they could use
that money that they
got from selling their
security to buy things,
and the person they
bought things from
could deposit it in a bank.
But one way or another we
can imagine it all gets
deposited in a bank.
So this is our private bank.
I'll call this private
bank number one.
So now all of these
dollars are transferred
to private bank number one.
And they are no longer--
the Federal Reserve,
or the Central Bank,
in the general case,
is no longer in
possession of them.
They've been transferred
right over here.
And I want to cross
these out just
so we can keep track of things.
Now when they deposit it
in private bank number one,
they said, well, I need three
of these dollars on demand.
And I want to write
checks against them.
So they put three of these
dollars in a checking account.
There are at three of these
dollars a checking account.
So checks up too-- so
write checks up to $3.
And so they can get a
little bit more interest,
and the bank's willing to give
a little bit more interest
on a savings account
because they don't have
to keep the reserves, they
put $1 into a savings account.
And they cannot write checks
against that savings account.
Now there are special
circumstances now,
but for simplicity, let's just
say that they cannot write
checks.
There are some that have
restricted check writing
and things like that now.
So this bank says, OK,
well, this dollar, I
don't have to even have
any reserves against it.
I could loan out this dollar.
And the person they
lend it to, let's
say that they immediately go and
deposit it into another bank.
So they immediately go and
deposit this in private bank,
I'll call this private bank two.
So it's no longer
in private bank one.
Let me draw a private bank two.
Private bank two is
a right over here.
Private bank number two.
And they deposit it
into a savings account
in private bank number two.
And let's say all of
this, out of all of this,
the bank says, well,
this is a demand deposit,
I have to keep some reserves.
This is a fractional
reserve system.
But I can lend out, in the
US, I could lend out up to 90%
of this.
And maybe this bank is a
little bit more conservative,
They only lend out 2/3 of this.
So they lend out
$2 out of these $3
And let's say the person
they let it do also
happens to deposit it
in private bank number
two, just coincidentally.
So these two also end up
in private bank number two.
And so they're no longer
in private bank number
one, although this person could
still write checks up to $3.
And now here in
private bank number
two-- and let's say
these are deposited
in a checking account.
These are deposited right over
here in a checking account.
Now private bank number two,
it can do a couple of things.
In this checking account it
has to keep some reserves.
Let's say it's even
more conservative.
It only decides to
lend out half of this,
even though it
could lend out 90%.
And so it lends out
one of these dollars.
And the person that they lend
it to just takes that dollar
and they put it in their wallet.
So they just put
it in their wallet.
And they could also lend
out this entire savings.
And let's just say
that the person
that they lend that
$1 in savings to also
puts it in their wallet.
And notice, the original
$4 are still there.
One, two, three, four.
Now, and just to be clear,
this person right over here can
write checks up to $3 .
And this person
right over here can
write checks-- let me do
that same checking account
color-- they can
write checks up to $2.
Now let's think about the
different forms of money
there are here.
Well, we could think of money in
a very, very narrow way, which
is just what did the Central
Bank print, or create
electronically as electronic
reserves of its member banks?
But for simplicity
here you can just
think about the physical
currency that it printed,
its base money.
And so that, often, is just
referred to as base money.
And in the US and
other countries
it's often the same thing as M0.
There's slight differences
from country to country.
And in this example, as soon
as they printed it and put it
into circulation, that was $4.
We had $4 of base money.
And that's obvious because
as soon as they printed this
and they bought the
security with it,
and it was in circulation, that
$4 could be used to buy things.
It could be used to
facilitate transactions.
Now that clearly isn't
all of the stuff that
can be used as money in this
little universe we created.
This guy, you have the
$4 but these people
can also write checks
right over here.
And so we can have a slightly
broader definition of money.
And over here, we
will call it M1.
And here, there's a couple of
ways you could think about it.
You could think about it as
all of the currency that's
in people's pockets plus all of
the check writing capabilities.
So if you view it
that way it, would
be this $2 plus $5 of
check writing capabilities
right over here.
So you could have $2
of physical currency
that's in people's wallets,
not in bank reserves,
plus the $5 of check
writing capability,
which would give you $7.
Another way you
could view it, you
could view it as M0
plus checkable deposits.
I'll just write checks
here, plus-- well
I'll write-- checkable deposits.
But if you do that,
you are now double
counting because
some of the M0 is
reserves in the
checkable deposits.
Or you could say some of
the checkable deposits
is held as reserves for M0.
So then you would have to
subtract out the bank reserves.
And so then you would
get $4 because we
don't want to double count
these right over here.
You would get M0 is $4.
And I want to do that in white.
M0 is $4.
The checkable deposits is $5.
Let me do that in the pink.
Plus the $5.
And then you would want to
subtract out the reserves.
And the reserves here, there
are $2 of the reserves.
So minus $2.
And you would get
yourself back to the $7.
And the whole point of this is
so you're not double counting
something, you're not double
counting this right over here,
as part of checkable
deposits and part of the M0.
You're not using this twice.
It's not part of the base money.
It is both the base money
and checkable deposits.
And we don't want
to count it twice.
So the simplest
way to think about
is, well, what can be used
in this broader definition
to facilitate transactions?
These $2 in people's
pockets, and this ability
to write up to $5 of checks.
So that's this view
right over here.
And if we want to get
even broader than that,
we can get to
something called M2.
And here we could say,
OK, what's immediately
usable to facilitate a
transaction right now?
So that would be our M1.
So that would be our $7 of M1.
Plus things that can be
easily converted to M1.
So for example, these
savings accounts
can be easily converted
to checking accounts.
It might only take
a couple of days.
There might be
some restrictions.
But it can be converted.
And when it gets converted
will change the bank's reserve
requirements a little bit.
But it will allow, if
this person converts it
they will have the ability
to write more checks.
So M2 includes M1
plus things that
are very easy to convert to M1.
And so they'll include things
like savings accounts, money
market accounts, which I
won't go into detail here.
But they're really kind
of similar in that you
get slightly higher
interest, but there
are restrictions on your
ability to access it.
But it's not too hard to turn
it into checking accounts.
And small dollar value
time deposit, CD accounts.
But for the sake of
simplicity, in this example,
it would be the saving accounts.
So it would be our
$7 of M1, plus the $2
of savings accounts
right over here.
So this is just to
give you a picture.
When someone talks
about the money
supply you really
have to say, well,
what are you talking about?
The most typical one is that
you're really talking about M1,
because this is the stuff that's
directly usable to facilitate
transactions.
Things like the ability
to write a check,
or dollar bills in
someone's wallet.
But they might be talking about
base money, M0, narrow money,
always of referring
to the same thing,
especially in the United States.
Or they might be referring
to something even broader.
And there are
broader definitions
even than M2,
although M3, they've
stopped reporting about it.
But M3 would have things
that are a little bit further
from being true money, from
being a checking account.
But they are already
fairly liquid
and so they'll include
other types of assets.
But the Fed has
stopped reporting
this in the recent past.
So these are the ones that
are typically referred to.