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Chapter 25: Problem 1

What is the main difference between the \(\mathrm{M} 1\) and \(\mathrm{M} 2\) definitions of the money supply? Why does the Federal Reserve use two definitions of the money supply rather than one?

Short Answer

Expert verified
The primary difference between M1 and M2 lies in the liquidity of the assets they include; M1 only covers highly liquid forms while M2 extends to less liquid assets. The Federal Reserve uses both definitions to adjust their monetary policies based on the liquidity of money and to understand the overall economic trend.

Step by step solution

01

Define M1

M1 is a narrow measure of the money supply that includes only the most liquid forms of money; it includes currency, demand deposits, and other current accounts that can be easily converted to cash.
02

Define M2

M2 is a broader measure that includes everything in M1, as well as less liquid types of money. Specifically, M2 includes savings deposits, money market mutual funds and other time deposits, which are less liquid than M1 assets but can be converted into cash relatively easily.
03

Explain why the Federal Reserve uses two definitions

The Federal Reserve uses M1 when it wants to target short-term interest rates and control inflation, as it is a more liquid form of money and can circulate quickly. On the other hand, M2 is used when the Federal Reserve wants a broader perspective on the money supply to understand the overall trends in the economy.

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