Difficulty: Introductory | Prerequisites: Basic understanding of banking (what a checking account and savings account are).
Money supply is one of the central pillars of macroeconomics. Understanding how economists measure money in the economy is essential before you can make sense of monetary policy, inflation, or how the Federal Reserve operates. This topic introduces the three standard "tiers" of money (M0, M1, M2), each of which captures a different slice of the economy's total money based on how liquid it is. If you've missed recent lectures, start here: this is foundational for everything that follows on the Fed, interest rates, and monetary policy.
Economists measure the money supply in layers. M0 is physical currency in circulation. M1 adds the most liquid bank deposits (like checking accounts) on top of M0. M2 adds less liquid savings instruments on top of M1. Each broader measure includes everything in the narrower one, so M0 is always the smallest and M2 the largest.
M0 (Monetary Base / Base Money)
The total amount of physical currency (coins and notes) in circulation. This is the narrowest, most liquid measure of money. In simple terms, it is the cash people are carrying around or keeping in a till.
M1 (Narrow Money)
M0 plus demand deposits such as checking accounts and other highly liquid deposits that can be spent almost immediately. Think of it as all the money you could spend today without waiting.
M2 (Broad Money)
M1 plus near-money assets that are less liquid, such as savings accounts, money market accounts, and certificates of deposit (CDs) under a certain size. Think of it as everything in M1, plus the money you could access within a few days or after a small penalty.
Liquidity
How quickly and easily an asset can be converted into spendable cash without significant loss of value. Cash is the most liquid asset. A five-year CD is much less liquid because you face a penalty for early withdrawal.
Certificate of Deposit (CD)
A time deposit held at a bank for a fixed term (e.g. 5 years) at a fixed interest rate. You agree not to touch the money for the term. CDs are included in M2 but not M1, because they are not immediately spendable.
Demand Deposit
A bank deposit (typically a checking account) that can be withdrawn at any time without notice or penalty. Demand deposits are included in M1.
M0 is entirely contained within M1, which is entirely contained within M2.
Each broader measure adds less liquid assets on top of the previous tier:
M0 = currency in circulation
M1 = M0 + demand deposits (checking accounts, traveller's cheques, other checkable deposits)
M2 = M1 + savings deposits + small-denomination time deposits (CDs) + money market funds
Because of this nesting, M0 can never exceed M1. M1 includes all of M0 plus additional components. Even if demand deposits dropped to zero, M1 would still equal M0. For M0 to exceed M1, demand deposits would have to be negative, which is not possible.
As you move from M0 to M1 to M2, you include progressively less liquid assets.
M0 assets (cash) are perfectly liquid: you hand over notes and the transaction is done.
M1 adds demand deposits, which are nearly as liquid as cash (you write a cheque, tap a card, or transfer instantly).
M2 adds instruments that require time, notice, or a penalty to convert to cash (savings accounts, CDs, money market funds).
The trade-off: less liquid assets generally earn a higher return. A five-year CD pays interest precisely because you are giving up immediate access to your funds.
The key skill for exams is tracing what happens to each measure when money moves between categories. The rules:
Moving money between components within the same tier changes nothing at that tier or above. For example, moving cash into a checking account changes the composition of M1 but not its total, because both cash and checking accounts are in M1.
Moving money from a lower tier to a higher tier reduces the lower measure. Transferring funds from a checking account (M1) to a CD (M2 only) reduces M1 but leaves M2 unchanged.
No money is created or destroyed in simple transfers between private parties. The total amount in the broadest relevant measure stays the same unless the banking system creates new money (a topic for later).
Initial values: M0 = $100,000, M1 = $240,000, M2 = $400,000. A person transfers $100,000 from a checking account to a five-year CD.
The checking account balance falls by $100,000. Checking accounts are in M1 (and M2).
The CD balance rises by $100,000. CDs are in M2 only, not M1.
M0 = $100,000 (no change, no physical cash involved)
M1 = $240,000 − $100,000 = $140,000 (checking deposit left M1)
M2 = $400,000 (no change, the money moved from one M2 component to another M2 component)
Initial values: M0 = $60,000, M1 = $130,000, M2 = $350,000. Someone purchases a $35,000 car with cash. The dealership deposits that cash into its business checking account.
This is a two-step transaction, but the net effect is what matters:
Cash ($35,000) leaves physical circulation (M0) and enters a checking account (M1).
Both cash and checking accounts are components of M1, so M1's total does not change: the cash portion shrinks and the checking-account portion grows by the same amount.
Similarly, both are components of M2, so M2 does not change either.
M0 = $60,000 − $35,000 = $25,000 (cash is now in a bank, no longer circulating as physical currency)
M1 = $130,000 (no change, one M1 component replaced another)
M2 = $350,000 (no change)
Initial values: M0 = $210,000, M1 = $400,000, M2 = $900,000. A business withdraws $10,000 from its checking account for miscellaneous expenses.
Cash comes out of the bank (M0 increases) and the checking account balance drops (but checking accounts are also in M1).
Both cash and checking deposits are M1 components, so M1 stays the same.
Both are also M2 components, so M2 stays the same.
M0 = $210,000 + $10,000 = $220,000 (more physical cash in circulation)
M1 = $400,000 (no change, one M1 component replaced another)
M2 = $900,000 (no change)
M1 = M0 + demand deposits + other checkable deposits
M2 = M1 + savings deposits + small time deposits (CDs) + money market funds
M0 ≤ M1 ≤ M2 (always, by definition)
Central banks track these measures to gauge how much spending power exists in the economy. When the Federal Reserve talks about "the money supply," it is usually referring to M1 or M2. A sharp rise in M2 relative to M1 might signal that people are saving more and spending less, which matters for forecasting economic activity.
"Depositing cash at a bank destroys money." It does not. It changes the form of the money (from currency to a deposit) and shifts it between M0 and M1 components, but total M1 is unchanged.
"M0, M1, and M2 are separate pools of money." They are not. They are nested. Every dollar in M0 is also counted in M1 and M2.
"Transferring money between accounts always changes M1." Only if the transfer crosses a tier boundary (e.g. checking to CD). Moving money between two checking accounts changes nothing.
"Spending cash reduces the money supply." Spending cash transfers it to someone else. The money supply only changes when money enters or leaves the banking system in specific ways (e.g. the central bank's operations).
⚠️ The nesting relationship (M0 ⊂ M1 ⊂ M2) is tested frequently. Be ready to explain why M0 can never exceed M1.
⚠️ Calculation questions will give you initial values and a transaction, then ask for the new M0, M1, and M2. Trace which component gains and which loses, and check whether they are in the same tier.
⚠️ Know the liquidity ordering: M0 is most liquid, M2 includes the least liquid assets.
⚠️ CDs are in M2 but not M1. This is the most commonly tested boundary.
True or False: M1 includes savings accounts. False. Savings accounts are part of M2, not M1.
True or False: If someone withdraws cash from a checking account, M1 decreases. False. Both cash and checking accounts are M1 components, so M1 stays the same.
Fill in the blank: M2 = M1 + ______ + small time deposits + money market funds. Savings deposits.
True or False: M0 could theoretically equal M1. True. If demand deposits and other checkable deposits were zero, M0 would equal M1.
Q: Why is it impossible for M0 to be greater than M1?
A: M1 is defined as M0 plus demand deposits and other checkable deposits. Since demand deposits cannot be negative, M1 must always be at least as large as M0.
Q: A person transfers $50,000 from a checking account to a savings account. Initial values: M0 = $80,000, M1 = $200,000, M2 = $500,000. What are the new values?
A: M0 = $80,000 (unchanged). M1 = $200,000 − $50,000 = $150,000 (checking left M1). M2 = $500,000 (unchanged, both checking and savings are M2 components).
Q: Explain the relationship between the aggregate measures of the money supply and liquidity.
A: The narrower the measure, the more liquid its components. M0 (cash) is perfectly liquid. M1 adds near-cash deposits. M2 adds assets that take more time or incur penalties to convert to cash. Each successive measure trades liquidity for a broader picture of the economy's total money.
Q: Does buying something with cash change M0?
A: Only if the recipient does something different with the cash than the buyer was doing. If the buyer had cash and the seller also holds it as cash, M0 is unchanged. If the seller deposits it, M0 falls (but M1 stays the same).
This material connects directly to monetary policy: the Federal Reserve influences the money supply to manage inflation and employment. Understanding M0, M1, and M2 is prerequisite knowledge for studying the money multiplier, fractional reserve banking, and open market operations. It also links to the next topic in this set, interest rates and bond prices, since interest rates are one of the Fed's primary tools for influencing how money moves between these tiers.
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