Final answer:
The money supply in an economy is defined as M1 and M2 by the Federal Reserve Bank, with M1 being more liquid than M2. Monetary policy affects the money supply and, in turn, the economy's performance. M2 includes less liquid assets like savings accounts and CDs, in addition to everything in M1.
Step-by-step explanation:
Understanding M1 and M2 Money Supply
When discussing the money supply, we refer to the total amount of money within an economy that can be used for transactions. The Federal Reserve Bank, the central bank of the U.S., defines money based on its liquidity: M1 money supply and M2 money supply. M1 includes very liquid forms of money such as cash and checking accounts, while M2 includes M1 plus savings accounts, certificates of deposit, and money market funds, which are less liquid. The money supply is crucial to a nation's economy and is influenced by the banking system's ability to create money.
Monetary policy plays a significant role in controlling inflation and stimulating economic growth. However, it's not always straightforward due to the unpredictable nature of the economy's response times, banks' reserve decisions, and changes in the velocity of money. One way to understand the money supply's role in the economy is through the basic quantity equation of money, MV = PQ. M stands for the money supply, V for velocity, P for the price level, and Q for real output.
Remember that M2 is less liquid than M1. The distinction lies in how quickly the assets can be made available for transactions. For instance, savings accounts and certificates of deposit typically have some restrictions on withdrawals, making them less liquid than checking accounts which are readily available for use.