Question

4. Indicate what would happen to both M1 and M2 (increase, decrease, no change) due to each of the following events. Consider each lettered event to be independent of the others.

a) you write a check for cash at the casino

b) an individual redeems a personal CD and deposits the funds into a savings deposit account

c) U.S. commercial banks use some of their excess reserves to purchase $250 billion worth of U.S. Treasury securities from the Federal Reserve.

d) as the economy improves, banks ease their credit standards and approve a higher percentage of loan applications.

e) you spend $4,000 in U.S. currency while on your spring break trip to Acapulco (if you spent less than that you could not have had much fun)

Answer 1

M1 money supply includes money that is very liquid such as coins and notes as well as checkable deposits or demand deposits.

M2 money supply includes M1 plus all other short-term and medium-term deposits of the domestic private sector with monetary institutions.

In part a) M1 and M2 both will increase because payment in the casino with a cheque is considered as demand deposits, as the casino owner will deposit the cheque in his bank and can withdraw the cash from his savings account in the bank, Ultimately cash flow will increase, hence M1 will increase too which leads to an increase in M2 as well.   

In part b) A certificate of deposit is a short-term bond. As consumer redeems his CD, M2 will decrease because of the decrease in the short-term deposit then deposits the fund in his savings account therefore M2 will increase(as you can not write checks directly for savings account but you can withdraw amount through ATM or bank so savings account is also a short-term deposit)

Ultimately M2 and M1 will remain unchanged.

In part c) Excess Reserves are not the part of M1 or M2 because it is part of the monetary base(MB). Therefore, if we consider U.S. treasury securities as Short-term or medium-term deposits(like treasury bills) purchase of these securities by commercial banks from U.S Federal Reserve will increase M2 by the amount of $250 billion.   

In part d) Increase in loan applications, will increase the money supply M2 and M1 in the economy because of the money multiplier effect.

For example, Suppose a deposit of amount 'x' is made by person A then the bank is required to keep some fraction 'r' as reserves and can lend out the rest i.e. x(1-r) to suppose person B. Bank will deposit the loan amount into his bank account and like person A's account B's account is also based on fractional reserve principle. So the amount x(1-r)² gets lent out of it to suppose person C and the story goes on. That's how the bank can grow money supply much larger than the base amount.

In part e) M2 and M1 both will decrease because $4000 spend in Acapulco will Acapulco Dollar reserve but decrease the U.S. money supply (M1 and M2).