12.3: Money Classification (Aggregates)

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Page ID: 287995

Martin Medeiros
Chabot College

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What is money? If you answered cash, you are correct. But there are many other types of money circulating in the economy other than cash.

Most people associate money with the ability to exchange it for goods and services. But this is not the only role money plays. Money is anything that meets all three of these criteria:

Medium of exchange; is accepted as payment for goods and services (and debts).
Store of value; can be held for future purchases.
Unit of account; serves as a standard for measuring the prices of goods and services.

Based on this broad definition of money, the following money classifications have been developed:

The classification of money that is most closely associated with the medium of exchange criteria is M1.

Sometimes called the narrowest definition of money, M1 consists of the following:

Cash (paper and coin) in circulation
Traveler’s checks
Demand deposits (e.g., checking accounts), sometimes called transaction accounts
Other checkable deposits

Since M1 can be easily exchanged for goods/services and inputs, it is considered to have a high degree of liquidity (i.e., Ease with which an asset can be converted to goods and services).

The classifications of money that are most closely associated with the store of value criteria is M2.

M2 consists of the following:

M1
Savings deposits (including money market deposit accounts)
Small time deposits (<$100,000 for each account)
Money market mutual funds

Figure 2

When someone speaks of the ‘money supply’, it is necessary to ask if they are speaking of money in narrow (M1) or broad (M2) terms.

The amount of money circulating in the economy affects the consumer’s ability to purchase goods and services (i.e., demand) and the firm’s ability to purchase factor inputs (i.e., supply). The link between economic activity and the money supply is established with interest rates. As with any commodity, if you ‘flood the market’ with supply, this will have a depressing effect on its price. And the price of money is the interest rate.

If the ups and downs of the business cycle are too wild, then control of the money supply can be used to stabilize economic activity in the short run and promote economic growth in the long run. See figure 3.

Figure 3

There are two important points to make:

The connection between changes in the money supply is contingent upon the willingness and ability of households and firms to borrow.
There are those who question the benefits of money supply manipulation on long run growth. Some say that micromanaging the money supply leads to adverse changes in the inflation rate.

It should be clear that money is a very important component in any economy. Later in this chapter we will examine how money is created.

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