An economy's money supply is often divided into four parts — M0, M1, M2, and M3. The M1 money supply is a measurement of the total amount of currency in circulation. It consists of M0, which is paper currency and coins, plus publicly held checking accounts. Other forms of M1 currency are: traveler's checks, automatic transfer service accounts, and credit union accounts. Economists often use the M1 money supply measurement as an indicator of inflation.
In the US, M1 is money that is issued to commercial banks by the US Federal Reserve for deposits and loans. The total amount of money in circulation often affects the flow of economic activity. M1 is generally used in conjunction with the M2 and M3 money supply measurements by economists to gauge how much money is in circulation. M2 consists of M1 plus savings accounts. The M3 money supply consists of M2 plus large commercial deposits.
The US Federal Reserve often manipulates the M1 money supply to control inflation. If the Federal Reserve issues or prints too much money, the result is inflation and a rise in prices. A rise in the price of goods and services often reduces spending by consumers and a loss of revenue for business owners.
A common solution often used to fight inflation is to decrease the money supply. In effect, the Federal Reserve stops printing money. The goal of reducing the money supply, generally, is to lower inflation and prices.
Lowering the money supply, many economists argue, could harm the overall economy without lowering inflation. Oftentimes, reducing the M1 money supply not only reduces inflation and prices, but often reduces the purchasing power of consumers. With less money to spend, many consumers will usually only purchase the goods and services that they need.
In conjunction with money supply manipulation, the Federal Reserve often raises interest rates to control inflation. Usually, the US Federal Reserve only adjusts interest rates whenever it feels that prices are increasing enough to cause inflation. An interest rate increase usually attempts to reduce the amount of money in circulation. This interest rate increase is generally 1 percent or less depending on economic conditions. If the Federal Reserve raises interest rates too sharply, it may result in a reduction in borrowing by consumers and businesses.
Like M1 money supply reduction, raising interest rates may reduce consumer spending and hinder business activity. When interest rates increase many consumers and business owners often will not purchase the goods they want because it costs too much to borrow money.