But exactly how much money is there and what forms does it take? Economists and investors ask this question to determine whether there is inflation or deflation. Money is divided into three categories to make it more distinguishable for measurement purposes:
M1 – This category of money includes all physical denominations of coins and coins; demand deposits, which are checking and NOW accounts; and traveler’s checks. This category of money is the narrowest of the three and is essentially money that is used to buy things and make payments (see the “active money” section below).
M2: By broader criteria, this category adds all the money in M1 to all non-institutional time deposits, savings account deposits, and money market funds. This category represents money that can be easily transferred to cash.
M3 – The broadest money class, M3 combines all the money found in the M2 definition and adds to it all the large time deposits, institutional money market funds, short-term repurchase agreements, along with other more liquid assets . big.
By adding these three categories, we arrive at the money supply of a country or the total amount of money within an economy.
Category M1 includes what is known as working money: the total value of coins and paper money in circulation. The amount of active money varies seasonally, monthly, weekly and daily. In the United States, the Federal Reserve banks distribute new currency to the United States Department of the Treasury. Banks lend money to customers, which becomes working money once it is actively circulating.
The variable demand for cash equates to a constantly fluctuating total active money. For example, people often cash paychecks or withdraw money from ATMs on the weekend, so there is more active money on Mondays than on Fridays. Public demand for cash declines at certain times, such as after the December holiday season.
How money is created
We have discussed why and how money, a representation of perceived value, is created in the economy, but another important factor that affects money and the economy is how a country’s central bank (the central bank in the United States is the Federal Reserve or Fed) can influence and manipulate the money supply.
If the Fed wants to increase the amount of money in circulation, perhaps to revive economic activity, the central bank can obviously print it. However, physical bills are only a small part of the money supply.
Another way the central bank can increase the money supply is by buying government fixed income bonds on the market. When the central bank buys these government bonds, it puts money on the market and, effectively, in the hands of the public. How does a central bank like the Fed pay? Oddly enough, the central bank simply creates the money and transfers it to those who sell the securities.7 Alternatively, the Fed can lower interest rates by allowing banks to make cheap loans or credits, a phenomenon known as cheap money, and encouraging businesses and individuals to borrow and spend.
To reduce the money supply, perhaps to reduce inflation, the central bank does the opposite and sells government bonds. The money that the buyer pays to the central bank is essentially withdrawn from circulation. Note that in this example we generalize to keep things simple.