“The U.S. money supply comprises currency-dollar bills and coins issued by the Federal Reserve Systemand the U.S. Treasury-and various kinds of deposits held by the public at commercial banks and other depository institutions such as thrifts and credit unions”. It is apparent that there are different kinds or types of money, and the Federal Reserve has classified money as M1, M2, and M3 money. M1 money is currency, travelers’ checks, demand deposits, and other checkable deposits (Melicher, Norton, and Town 2008, p.49, and p. 50).
An equation to express M1 money would be “M1 = currency in circulation + checkable deposits + traveler’s checks”. To illustrate, if you were to go to the bank, cash your payroll check, and receive cash in return this would be an example of M1 money. The household checking account that you would place a small amount of your paycheck in to pay a cable bill would also be an example of M1 money.
M2 money emphasizes “money as a store of value in addition to its function as a medium of exchange” (Melicher 2008 p. 51). An equation to explain M2 money would be “M2 = M1 + savings deposits + small time deposits (CDs
M3 takes an even “broader view of money as a stockpile of value” (Melicher 2008 p. 52). It can be expressed as “M3 = M2 + large time deposits”. Melichar (2008) mentions, that Eurodollars and repurchase agreements issued by depository institutions are also a part of the M3 money supply. It should be clear from the equation cited, that M3 money typically cannot be easily converted to M1 money, and it is a much larger store of value. For example, the Fidelity Institutional Money Market fund has a $1,000,000 minimum to invest. This type of fund is not currency, and certainly cannot be easily converted to currency (can you imagine cashing in this fund and taking your money home)? However, it is real money; it is M3 money as defined by the Federal Reserve. It is essential to realize that M3 money usually refers to extremely large transactions by large entities.
Interest refers to the cost of money (Melicher 2008 p. 56). Businesses, banks and other financial institutions have to factor interest rates in their operational costs (Melicher 2008 p. 56). Institutions either pay interest to consumers or pay interest as an expense for borrowed money. Businesses need money to operate, to grow, and to expand and those funds must be borrowed, raised, or somehow procured. Businesses have to consider how much borrowed money will cost.
The cost of money is an expense that should be factored into the operation of the business like all other expenses. If interest rates are low, the cost of money is low and businesses are more likely to borrow, invest, grow and expand which in turn will cause economic growth. The textbook mentions that, “depository institutions make profits by achieving a spread between the interest rates they pay individuals on savings accounts, and the interest rates they charge businesses and other individuals for loans” (Melicher 2008 p. 59). Interest therefore affects the economy in numerous ways, affecting the interest banks pay for savings accounts, interest on home loans, auto loans, and credit card accounts.
When interest rates are low, more consumers will purchase big-ticket items and make investments, and when interest rates are high consumers may tend to spend less. Often times the picture from a monetary policy standpoint is not so clear. Melichar (2008) mentions the position that monetarists take with regard to supply of money and what happens when the supply exceeds demand. The result is a rapid increase in economic activity, with inflation being the aftereffect. Monetarists believe that when the supply of money exceeds the amount of money demanded the public will spend more rapidly causing real economic activity or prices to rise. In the opinion of monetarists a ‘too rapid growth in the money supply, will ultimately result in the rising prices or inflation because excess money will be used to bid up the prices of existing goods” (Melicher 2008 p. 54).
Since low interest rates spur economic activity, why policy makers would ever raise interest rates is a legitimate question. The Federal Reserve recognizes that the economy needs a healthy amount of economic activity and economic growth. To check inflation the Fed has at times made the decision to raise interest rates to slow or check economic activity and to cool the economic engine. The result of such a strategy would be a slowing economy with lower inflation. It is clear that the money supply, the Fed, and policy makers all have an impact on the economy and inflation can certainly promote or stifle economic growth.
Melicher, R. W., Norton, E. A., & Town L. (2008). Finance: Foundations of Financial
Institutions and Management. Strayer University. John Wiley and Sons, Inc. http://www.oswego.edu/~edunne/200ch13.html