1.5 Measuring Money

When viewing economies as a whole, money is measured in three main ways: purchasing power, M1, and M2. Changes in purchasing power are related to interest rates, economic growth, and inflation (or deflation). Inflation refers directly to the purchasing power a specific currency has. When inflation occurs, the price of goods rises in an economy. For example, today a gallon of gas may cost $3. Let’s say something happens, and tomorrow inflation suddenly increases by 50%. That same gallon of gas would then cost you $4.50. The purchasing power of $3 declined as a result of the inflation. Typically, the main cause of inflation is too much money circulating in the economy.

A second way money is measured by economists is through a mechanism referred to as money aggregates. There are several variations, but here we will cover two. The first is referred to as M1. The M1 money aggregate is estimated using only the most liquid assets in the economy. M2, on the other hand, includes assets that are not necessarily considered liquid or used as a means of payment. While both measures are theoretically valid and important to understand, they are rarely used by practitioners because both are poor forecasters of inflation. One thing changes in M1 and M2 do tell us is that at low levels of money growth, inflation is likely to stay low.