Difficulty: Introductory | Prerequisites: None beyond a basic understanding of bank accounts.
Big Picture
The money supply is how economists measure the total amount of money circulating in an economy. It is broken into tiers (M0, M1, M2) based on liquidity, meaning how quickly and easily each type of money can be spent. Understanding these categories is essential for grasping how central banks control the economy and why certain policy moves (like changing reserve requirements) have the effects they do. This section also practises the exam's favourite trick: giving you a transaction and asking you to recalculate each tier.
TL;DR
M0 is physical currency, M1 adds checking accounts, and M2 adds less-liquid items like savings accounts and CDs. Moving money between categories changes individual tiers but usually leaves M2 unchanged. The broader the measure, the less liquid it is.
M0 (monetary base / physical currency)
The narrowest measure of the money supply. M0 consists of all physical currency in circulation: notes and coins. It does not include money in bank accounts of any kind.
Think of it as the cash in people's wallets and tills.
M1
A broader measure that includes everything in M0 plus demand deposits (checking accounts). M1 captures money that can be spent immediately, either as cash or by writing a cheque or using a debit card.
In simple terms, M1 = cash + money you can spend right now from your bank account without any waiting period.
M2
The broadest commonly tested measure. M2 includes everything in M1 plus "near money": savings accounts, money market accounts, and small certificates of deposit (CDs). These are less liquid because converting them to spendable money may involve a delay or penalty.
Think of M2 as all the money that exists in forms people might reasonably spend, even if some of it takes a step or two to access.
Liquidity
How quickly and easily an asset can be converted into spendable cash without significant loss of value. Cash (M0) is perfectly liquid. A 5-year CD is much less liquid.
Certificate of deposit (CD)
A time deposit held at a bank that pays a fixed interest rate for a fixed term. Early withdrawal typically incurs a penalty. CDs sit in M2 but not in M1, because they cannot be spent on demand.
Demand deposit (checking account)
A bank account from which money can be withdrawn at any time without prior notice. Included in M1 because the funds are immediately accessible.
Nested structure of the money supply
M0 is a subset of M1, and M1 is a subset of M2. This means M0 can never exceed M1, and M1 can never exceed M2. Each broader measure contains everything in the narrower one, plus additional less-liquid assets.
M0 = Physical currency (notes and coins) in circulation.
M1 = M0 + demand deposits (checking accounts). Everything in M1 can be spent immediately.
M2 = M1 + savings deposits + money market accounts + small CDs. These additions are "near money," accessible but not instantly spendable.
Because each tier nests inside the next, M0 ≤ M1 ≤ M2 always holds.
As you move from M0 to M1 to M2, the aggregate measure grows larger but the additional assets become less liquid.
Cash (M0) is the most liquid asset. A five-year CD (included only in M2) is among the least liquid forms of money.
This inverse relationship between size of the aggregate and liquidity of the marginal components is a standard exam point.
The exam gives you starting values for M0, M1, and M2, describes a transaction, and asks you to recalculate. The key is tracking where money moves.
Rules of thumb:
Cash to checking (or vice versa): M0 and M1 change in opposite directions within their components, but M1 stays the same because both cash and checking are in M1. M2 also stays the same.
Checking to CD: M1 drops (checking is in M1, CDs are not), but M2 stays the same (both checking and CDs are in M2). M0 is unaffected.
Cash to CD: M0 drops, M1 drops (by the same amount, since cash is in both), but M2 stays the same.
Example 1: M0 = $100,000, M1 = $240,000, M2 = $400,000. A person transfers $100,000 from checking to a 5-year CD.
M0 = $100,000 (unchanged, no cash involved)
M1 = $240,000 - $100,000 = $140,000 (checking is in M1; CDs are not)
M2 = $400,000 (unchanged; both checking and CDs sit within M2)
Example 2: M0 = $60,000, M1 = $130,000, M2 = $350,000. Someone buys a $35,000 car with cash. The dealership deposits the cash into its business checking account.
M0 = $60,000 - $35,000 = $25,000 (cash leaves circulation and enters a bank)
M1 = $130,000 (unchanged; cash left M0 but entered checking, both of which are in M1)
M2 = $350,000 (unchanged)
Example 3: M0 = $210,000, M1 = $400,000, M2 = $900,000. A business withdraws $10,000 cash from its checking account.
M0 = $210,000 + $10,000 = $220,000 (more physical cash in circulation)
M1 = $400,000 - $10,000 = $390,000 (wait, this needs a closer look)
Note on Example 3: The practice material shows M1 dropping by $10,000 when cash is withdrawn from checking. However, both cash and checking are components of M1. A withdrawal from checking increases M0 but should leave M1 unchanged (cash goes up, checking goes down by the same amount, net effect on M1 is zero). The answer given in the practice materials (M1 = $390,000) appears to contain an error. On an exam, apply the logic: if both the source and destination of funds are within the same aggregate, that aggregate does not change.
M2 = $900,000 (unchanged)
Students often think M0 could be larger than M1. It cannot, because M1 includes all of M0 plus checking deposits. M0 is always a subset of M1.
A frequent error is thinking that any transaction changes M2. Most reshuffling of money between cash, checking, and CDs leaves M2 unchanged, because all three sit within M2. M2 only changes when money enters or exits the banking system entirely (e.g. the central bank creates new money).
Some students assume that withdrawing cash from a checking account reduces M1. It does not: cash and checking are both components of M1, so the withdrawal is an internal reclassification, not a net change.
Confusing "less liquid" with "not money" is common. A savings account is less liquid than a checking account, but it is still counted in the money supply (within M2).
⚠️ Expect multiple calculation questions where you are given M0, M1, M2, a described transaction, and asked to recalculate all three. Track which aggregates contain the source and destination of the funds.
⚠️ The nested relationship (M0 ⊂ M1 ⊂ M2) is frequently tested as a conceptual question. Be ready to explain why M0 can never exceed M1.
⚠️ The inverse relationship between the size of the money supply measure and its liquidity is a standard short-answer prompt.
⚠️ Know the components of each tier cold: M0 = currency, M1 = M0 + checking, M2 = M1 + savings + money markets + small CDs.
True or false: M2 is always at least as large as M1.
True. M1 is a subset of M2.
Fill in the blank: M1 = M0 + ______.
Demand deposits (checking accounts).
True or false: Moving $5,000 from a checking account to a savings account changes M1.
True. M1 decreases because checking is in M1 but savings is not.
True or false: Moving $5,000 from a checking account to a savings account changes M2.
False. Both checking and savings are within M2.
Fill in the blank: As the money supply aggregate gets broader (M0 → M1 → M2), liquidity ______.
Decreases (declines).
Q: Explain the relationship between the aggregate measures of the money supply and liquidity.
A: As the aggregate measures of the money supply get broader (from M0 to M1 to M2), the additional assets included become less liquid. M0 (cash) is perfectly liquid. M1 adds checking deposits, which are highly liquid but slightly less so than physical cash. M2 adds savings accounts and CDs, which require extra steps or penalties to convert to spendable money.
Q: Why is it impossible for M0 to be greater than M1?
A: M1 includes M0 as a component. M1 = M0 + checking account balances. Since checking account balances are zero or positive, M1 is always at least as large as M0.
Q: Initial values: M0 = $100,000, M1 = $240,000, M2 = $400,000. A person transfers $100,000 from a checking account to a five-year certificate of deposit. Calculate M0, M1, and M2 after the change.
A: M0 = $100,000 (no cash involved). M1 = $240,000 - $100,000 = $140,000 (checking is in M1; CDs are not). M2 = $400,000 (both checking and CDs are within M2, so no net change).
Q: Initial values: M0 = $60,000, M1 = $130,000, M2 = $350,000. Someone purchases a $35,000 car with cash. The car dealership deposits the cash into its business checking account. Calculate M0, M1, and M2.
A: M0 = $60,000 - $35,000 = $25,000 (cash leaves circulation, enters a bank deposit). M1 = $130,000 (unchanged; cash left M0 but entered checking, and both are components of M1). M2 = $350,000 (unchanged).
Q: A family withdraws $2,000 in cash from their checking account to pay for a holiday. What happens to M0, M1, and M2?
A: M0 increases by $2,000 (more cash in circulation). M1 is unchanged (cash up by $2,000, checking down by $2,000, net zero within M1). M2 is unchanged.
The money supply tiers connect directly to monetary policy: when the Federal Reserve conducts open-market operations, it changes the monetary base (M0) and this ripples through to M1 and M2 via the money multiplier. Understanding these categories is also essential for the quantity theory of money (MV = PY), where M refers to one of these aggregates.
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