macroecon notes-unit5.docx - 5.01 The Money Supply Like the...

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5.01 The Money Supply Like the money in the United States, our money supply is currently made up of fiat money —money that has value because it is backed by the word of the federal government and not by gold or other valuable resources. There are three official measures of money you should become familiar with for the AP exam. o M1 : The smallest, most liquid form of money; M1 includes checkable or demand deposits, travelers' checks, coins, and currency. Vault cash is not counted in the money supply because it has already been counted when it is deposited in the bank. It is not in circulation. When we talk about the money supply, this is usually the segment we are describing. o M2 : This definition includes M1 plus savings and small (less than $100,000) time deposits. Time deposits must remain in the bank for a fixed length of time before they can be withdrawn. Other accounts less than $100,000 like money market deposit accounts and money market mutual funds are also counted in M2 and usually earn a higher interest rate than regular deposits. M2 is larger than M1 but less liquid. o M3 : This definition includes M2 plus large ($100,000 or more) time deposits. M3 is even less liquid than M2 because the money must stay in the bank longer. An example of M3 would be a 5-year certificate of deposit or a savings bond (which are usually held for 7 years before maturity). M3 is no longer reported by the Federal Reserve but is included here to give M2 context. It will not be tested on the AP exam. Today, currency is the largest percentage of M1. Perhaps more interesting is the fact that 30 years ago, the demand deposits plus other checkable deposits made up about 85% of M1. Why has the demand for cash grown so dramatically over the last 30 years? At first glance, one might think that the rise of technology (ATMs, point of purchase credit card acceptance, direct deposit, etc.) would have LESSENED the demand for cash but apparently not! Most economists think that the rise in the demand for cash is caused by two factors: (1.) the rise of the underground economy and (2.) the use of U.S. $100 bills around the world as a form of international currency. Some economists estimate that 2/3 of the U.S. cash is overseas. Financial Assets Money is considered a financial asset. We learned in Module 4 that nations invest money and other financial capital in the country that has the highest interest rates so that they might get a higher return on their financial investment. (Remember, this is not the same as investment spending that is counted as part of GDP. Financial investment is not counted in GDP. In general, when you purchase a financial asset, you expect to gain some return on your investment. In many cases, you would earn interest and that increases your overall wealth.) Bonds are also a financial asset. A bond is a promise to pay the holder an amount equal to the cost of the bond along with a specified amount of interest earned. The bond holder
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agrees to keep the bond for a specified period of time. If you have a savings bond, you have loaned the U.S. government money and they have agreed to pay you back that
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