Monday, July 19, 2010
In the past few articles we have discussed what money is and how it can be inflated.
Since 1971, when all ties between currency and precious metals were removed, it has been increasingly difficult to define what money is. So how do we measure it if we have a hard time defining what it is?
Considering the amount of money that has been created in the past few years, it has become increasingly important to determine just how much. You have probably heard technical measures of money thrown around like M1 and M2. This shows the complexity that stretches well beyond the paper money in our pockets.
There are dozens of ways to quantify the amount of money in the system, and we will touch on a few.
Currency, monetary base
Coins and paper dollars in circulation are currency. They are what is considered legal tender and are used as a medium of exchange. This does not include money that is in government or bank vaults. The monetary base is all currency plus the deposits and commercial bank reserves held in Federal Reserve Banks. Measures of money are often classified into levels of M and the monetary base would be considered M0.
Under legal tender laws, monetary base is the money that can be considered the most liquid and most acceptable form of payment for goods and services.
M1 and M2
M1 is the level of measurement is all currency plus checking accounts, however, it does not include bank reserves.
A broader measure that economists use is M2. This is a reflection of money as well as close substitutes for money such as savings deposits. M2 is often used a key economic indicator to forecast a rise in prices due to inflation.
More information and research including graphs that show the exponential growth of the money supply can be found at research.stlouisfed.org
Several other measurements have been continually added over the years to give a clearer picture of the amount of money in the system. MZM and M3 include large institutional money market funds and large certificates of deposit (CDs). Also included in the measure of M3 are dollars that are held outside the U.S. This is important because foreign governments and companies then have the ultimate control of whether they hold on to these dollars or infuse them into the monetary base.
Why are there are so many ways to measure money
When the monetary system was closely tied to gold and silver, these complex measures were not necessary. A hard asset that had a very specific value backed every dollar. Now, in the age of debt and fractional reserve banking, exponential growth in the money supply creates the need for ever-changing ways to measure it. As I stated in previous articles, understanding the nature of money can help us make wise decisions in many areas of life.