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Definition of M2:

M2 is the measure of the money supply that includes M1, savings deposits, time deposits less than $100,000, and money market funds.  

Detailed Explanation:

There are several measures of money. Cash is accepted everywhere. But what about money in a traditional savings account that does not have check writing privileges? Technically it is not money, because it is not accepted as a medium of exchange. However it certainly is “near money” because it can be converted into cash within hours. In other words, it is liquid enough that most would consider deposits in a savings account as money. Economists use two measures of money depending upon the asset’s liquidity. M1 is the most limiting measure because it does not include savings accounts. M2 includes M1 and savings accounts.

M2 is a broader definition of money because it includes M1 and deposits that are referred to as “near money”. These include, savings deposits, certificates of deposit less than $100,000, and money market funds. Economists frequently prefer M2 because it is a more stable measurement of money. For example, assume Tyler purchases a $25,000 truck and is paying “cash” for it. He does not have enough money in his checking account, so he transfers money from his savings to his checking account. Before the transfer he has $10,000 in cash. He transfers $15,000 from savings. The table below illustrates how M1 would increase from $10,000 to $25,000 after the transfer, but M2 equals $25,000 before and after the transfer. 

M1 and M2 breakdown chart

Savings and time deposit accounts have restrictions. For example, certificates of deposit lose interest if they are cashed prematurely. Money market accounts may restrict the number of transactions and / or require a minimum check amount. Depositors may be required to give advance notice when withdrawing funds. Generally, longer term time deposits pay a higher interest rate than shorter term deposits. For example a five year CD may yield two percent, but a one year CD may pay only 1.5 percent. Higher interest rates are also paid on larger deposits.

The pie chart shows that M2 was approximately four times larger than M1 in January 2016. This is because M2 accounts pay a higher interest rate. Households and businesses prefer to deposit their money in accounts earning interest than in demand accounts paying little interest when money can easily be transferred between accounts. The graph illustrates the growth in M1 and M2 since 2000. The increase following the Great Recession in 2008 resulted from the infusion of money into the economy by the Federal Reserve to add liquidity to the economy.

M2 Pie Chart

Graph showing M1 and M2

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