Measures of Money Supply — AP Macroeconomics Study Guide

For: AP Macroeconomics candidates sitting AP Macroeconomics.

Covers: M1 and M2 monetary aggregates, classification of liquid vs near-money assets, calculation of narrow and broad money supply, and identification of money components for both AP multiple-choice and free-response questions.

You should already know: The three core functions of money, the definition of liquidity for financial assets, the role of central banks in issuing currency.

A note on the practice questions: All worked questions in the "Practice Questions" section below are original problems written by us in the AP Macroeconomics style for educational use. They are not reproductions of past College Board / Cambridge / IB papers and may differ in wording, numerical values, or context. Use them to practise the technique; cross-check with official mark schemes for grading conventions.

1. What Is Measures of Money Supply?

Measures of money supply are standardized hierarchical classifications of the total amount of money held by the non-bank public in an economy at a given point in time, created by central banks to track liquidity, set monetary policy, and report overall economic conditions. For the current AP Macroeconomics Course and Exam Description (CED), this topic is part of Unit 4: The Financial Sector, which accounts for 15-20% of the total AP exam score. Measures of money supply appear in both multiple-choice (MCQ) and free-response (FRQ) sections, most commonly as a calculation opening for a larger monetary policy FRQ or a classification question in MCQ. The core logic of measuring money supply is that not all financial assets are equally usable for transactions, so economists group assets by liquidity (how quickly they can be converted to cash without loss of value) into "monetary aggregates". For the AP exam, you only need to master the two core aggregates: narrow money (M1) and broad money (M2). Broader aggregates like M3 or MZM are not tested on the current CED, so you can ignore them for the exam.

2. M1: Narrow Money

M1 is the narrowest measure of money supply, designed to capture only the most liquid assets that can be immediately used as a medium of exchange for everyday transactions. By definition, M1 only includes assets that require no conversion to spend directly. The core components of M1 (per AP CED definition) are: currency in circulation (physical currency held by the non-bank public, not currency held in commercial bank vaults or at the central bank), demand deposits (checking accounts) at commercial banks, other checkable deposits (like NOW accounts), and traveler's checks (a very small component that is rarely used in modern economies but still included in the official definition). The formula for M1 is: $$M_1=\text{Currency in circulation}+\text{Demand deposits}+\text{Other checkable deposits}+\text{Traveler’s checks}$$ The intuition for excluding vault cash is that it is not held by the public, and it is already implicitly counted in the deposit balances that public customers hold at banks. Counting vault cash would lead to double-counting the same money.

Worked Example

A central bank publishes the following values for its economy (all in billions of dollars): Currency in commercial bank vaults = 120, Currency held by households and firms = 450, Demand deposits = 1100, Savings deposits = 800, Traveler's checks outstanding = 10. Calculate M1 for this economy.

1. First, separate eligible M1 components from ineligible ones. Currency in vaults is not part of currency in circulation, so we exclude it. Savings deposits are not checkable transaction accounts, so we also exclude them.
2. List eligible components: Currency held by the public (currency in circulation) = 450, demand deposits = 1100, traveler's checks = 10.
3. Sum the eligible components to get M1: $M_1=450+1100+10=1560$ billion dollars.
4. Confirm no double-counting: We correctly excluded bank-held currency, so no overcounting occurred.

Exam tip: On AP MCQ questions asking for M1, always cross out "vault cash" or "currency in bank vaults" immediately — this is the most common distractor used in these problems.

3. M2: Broad Money

M2 is the broader measure of money supply that includes all of M1 plus less liquid "near-money" assets. Near-money assets cannot be used directly for transactions (you cannot write a check from a standard savings account to pay for groceries) but can be converted to M1 (cash or checking) quickly with little to no loss of value, so they count as part of the overall money supply. The near-money assets added to M1 to get M2 are: savings deposits, small-denomination time deposits (certificates of deposit under $100,000), and retail money market mutual funds held by individual investors. The formula for M2 is: $$M_2=M_1+\text{Savings deposits}+\text{Small time deposits (<\$100,000)}+\text{Retail money market mutual funds}$$ M2 is the most commonly tracked measure of money supply by policymakers because it better reflects overall liquidity in the economy and is a more reliable predictor of future inflation than M1 alone. For the AP exam, you are expected to both calculate M2 from given components and classify assets into the correct aggregate.

Worked Example

Using the M1 calculation from the previous example, add the following additional values (all in billions of dollars): Savings deposits = 800, Small time deposits = 350, Retail money market mutual funds = 220, Large time deposits = 400. Calculate M2 for this economy.

1. We start with the pre-calculated M1 value of 1560 billion, since M2 always includes all components of M1.
2. Separate eligible near-money assets from ineligible ones: Include savings deposits (800), small time deposits (350), and retail money market mutual funds (220). Exclude large time deposits, which are not part of M2 per the AP definition.
3. Add the eligible near-money assets to M1: $M_2=1560+800+350+220=2930$ billion dollars.
4. Confirm the hierarchy: We did not subtract any M1 components, which follows the rule that all M1 is included in M2.

Exam tip: If a question asks whether a given M1 asset is part of M2, the answer is always yes — all M1 assets are included in M2, no exceptions.

4. Liquidity Hierarchy of Monetary Aggregates

Monetary aggregates are structured as a hierarchy based on liquidity, so there are clear rules for comparing their liquidity and total size. Because narrower aggregates only include the most liquid assets, the order of liquidity is inverse to the order of total size: $M_1$ is always more liquid than $M_2$, and $M_2$ is always larger in total value than $M_1$. This hierarchy reflects the difference between money for immediate spending (M1) and money held as a store of value that can be converted to spending money quickly (M2). For the AP exam, you will often be asked to classify assets into the correct category or compare the properties of M1 and M2, so understanding this hierarchy is just as important as being able to calculate the aggregates.

Worked Example

Classify each of the following assets as (i) both M1 and M2, (ii) M2 only, or (iii) neither M1 nor M2: (a) A $100billinyourwallet,(b)A$5,000 balance in your personal savings account, (c) A $2,000balanceinyourcheckingaccount,(d)A$10,000 small-denomination certificate of deposit, (e) A $10,000 share of Tesla stock.

1. First, recall the core hierarchy rule: All M1 assets are automatically part of M2, so no asset is M1 only.
2. Classify each asset: (a) A $100billinyourwalletiscurrencyincirculation,whichispartofM1\to soitis\ast \ast bothM1andM2\ast \ast .(b)A$5,000 savings account balance is a near-money asset added to M1 to get M2, so it is M2 only. (c) A $2,000checkingaccountbalanceisademanddeposit,partofM1\to soitis\ast \ast bothM1andM2\ast \ast .(d)A$10,000 small CD is a near-money asset, part of M2 but not M1 → so it is M2 only. (e) A share of Tesla stock is a financial asset but not money (it cannot be converted to cash quickly without price risk) → so it is neither.
3. Confirm against the hierarchy rule: We did not classify any asset as M1 only, which aligns with the hierarchical structure.

Exam tip: If a multiple-choice option includes the label "M1 only", that option is almost always wrong — only select it if the question explicitly asks to separate M1 from M2, which is extremely rare on the AP exam.

5. Common Pitfalls (and how to avoid them)

• Wrong move: Counting currency held in bank vaults as part of currency in circulation for M1. Why: Students assume all physical currency is counted, but vault cash is held by banks, not the public, and is already counted in customer deposit balances. Correct move: Always cross out "vault cash" or "currency in bank vaults" before adding components for any money supply calculation.
• Wrong move: Calculating M2 as only the sum of near-money assets, instead of starting from M1. Why: Students confuse the hierarchical structure, thinking M1 and M2 are separate mutually exclusive groups. Correct move: Always calculate M1 first, then add near-money assets to M1 to get M2.
• Wrong move: Classifying a M1 asset as "M1 only" on a classification question. Why: Students forget that all narrower aggregates are included in broader aggregates, so they treat M1 and M2 as separate groups. Correct move: Before answering any classification question, remind yourself "all M1 is M2", so M1 assets are always in both aggregates.
• Wrong move: Counting large time deposits, stocks, or government bonds as part of M2. Why: Students assume all financial assets are part of the money supply, but only small retail near-money assets are included in M2 per the AP definition. Correct move: Exclude all large time deposits, stocks, bonds, and other non-money financial assets from M1 and M2 calculations.
• Wrong move: Claiming M2 is more liquid than M1 because it has a larger total value. Why: Students confuse total size (sum of all assets) with liquidity (ease of spending the asset). Correct move: Memorize the fixed order: liquidity = $M_1>M_2$, total size = $M_2>M_1$, never reverse these.
• Wrong move: Counting deposits held by the government or central bank as part of M1. Why: Students forget that money supply only counts money held by the non-bank public. Correct move: Exclude all deposits held by the government or central bank from any money supply calculation.

6. Practice Questions (AP Macroeconomics Style)

Question 1 (Multiple Choice)

Use the table below for an economy, all values in billions of USD:

What is the value of M1 and M2 for this economy? A) M1 = $1100billion,M2=$2400 billion B) M1 = $1180billion,M2=$2480 billion C) M1 = $1100billion,M2=$2320 billion D) M1 = $400billion,M2=$2100 billion

Worked Solution: First, calculate M1 by adding only currency held by the public and demand deposits, excluding vault cash which is not held by the public. This gives $M_1=320+780=1100$ billion, eliminating options B (which incorrectly adds vault cash to M1) and D (which only sums currency values). Next, calculate M2 by adding all eligible near-money assets to M1: $M_2=1100+950+210+140=2400$ billion. Option C incorrectly subtracts vault cash from the M2 total, leading to an artificially low value. The correct answer is A.

Question 2 (Free Response)

An economy has the following monetary asset values (all in millions of local currency): Currency in circulation: 250, Demand deposits: 600, Savings deposits: 720, Large time deposits: 500, Retail money market mutual funds: 180, Small time deposits: 100.

(a) Calculate the value of M1 in this economy. Show your work. (b) Calculate the value of M2 in this economy. Show your work. (c) A household converts $100 million from their savings account to their checking account. Will M1 increase, decrease, or stay the same? Will M2 increase, decrease, or stay the same? Explain your reasoning for each.

Worked Solution: (a) M1 is the sum of currency in circulation and demand deposits, with no other eligible assets in this list: $$M_1=250+600=850\text{ million local currency}$$ (b) M2 equals M1 plus savings deposits, small time deposits, and retail money market mutual funds, excluding large time deposits: $$M_2=850+720+100+180=1850\text{ million local currency}$$ (c) M1 will increase. The $100millionwasheldinasavingsaccount,whichisnotpartofM1,somovingittoacheckingaccount(whichispartofM1)adds$100 million to total M1. M2 will stay the same. Both savings accounts and checking accounts are included in M2, so moving assets between two components of M2 does not change the total value of M2.

Question 3 (Application / Real-World Style)

The Federal Reserve reports that as of October 2024, U.S. currency in circulation is $2.3trillion,demanddepositsare$4.2 trillion, savings deposits are $11.8trillion,smalltimedepositsare$0.9 trillion, and retail money market mutual funds are $1.1 trillion. Calculate M1 and M2, then find the percentage of M2 that is made up of the most liquid (M1) assets. Interpret your result in context.

Worked Solution: First, calculate M1: $M_1=\$2.3\text{ trillion}+\$4.2\text{ trillion}=\$6.5\text{ trillion}$. Next, calculate M2: $M_2=6.5+11.8+0.9+1.1=\$20.3\text{ trillion}$. The percentage of M2 that is M1 is $\frac{6.5}{20.3}\times 100\approx 32\%$. Interpretation: This means that roughly two-thirds of the total U.S. broad money supply is held in less liquid near-money forms like savings accounts, rather than as immediately spendable narrow money for transactions.

7. Quick Reference Cheatsheet

8. What's Next

Mastering measures of money supply is the foundational prerequisite for the next core topics in Unit 4: the money creation process by commercial banks and the role of the money multiplier. You cannot correctly calculate the change in the money supply from open market operations or reserve requirement changes if you do not understand what counts as money in the first place. Beyond Unit 4, measures of money supply are a core input for analyzing monetary policy, inflation, and aggregate demand in later units, as changes in money supply directly impact interest rates and macroeconomic output. Next, you will apply what you learned here to bank balance sheets and money creation. Follow-on topics to study next: Money Creation and the Money Multiplier Central Bank Open Market Operations Monetary Policy and Aggregate Demand