The Federal Reserve measures the money supply using three main monetary aggregates: M1, M2, and M3.
M1 is the narrowest measure of the money supply, including only money that can be spent directly. More specifically, M1 includes currency and all checkable deposits . Currency refers to the coins and paper money in the hands of the public. Checkable deposits refer to all spendable deposits in commercial banks and thrifts.
The M1 measure includes currency in the hands of the public and checkable deposits in commercial banks.
A broader measure of money than M1 includes not only all of the spendable balances in M1, but certain additional assets termed "near monies". Near monies cannot be spent as readily as currency or checking account money, but they can be turned into spendable balances with very little effort or cost. Near monies include what is in savings accounts and money-market mutual funds. The broader category of money that embraces all of these assets is called M2. M3 encompassed M2 plus relatively less liquid near monies. In practice, the measure of M3 is no longer used by the Federal Reserve.
Imagine that Laura deposits $900 in her checking account in a world with no other money (M1=$900). The bank sets 10% of the amount aside for required reserves, while the remaining $810 can be lent out by the bank as credit. The M1 money supply increases by $810 when the loan is made (M1=$1,710). In the meantime, Laura writes a check for $400. The total M1 money supply didn't change; it includes the $400 check and the $500 left in the checking account (M1=$1,710). Laura's check is accidentally destroyed in the laundry. M1 and her checking account do not change, because the check is never cashed (M1=$1,710). Meanwhile, the bank lends Mandy the $810 credit that it has created. Mandy deposits the money in a checking account at another bank. The bank must keep 10% as reserves and has $729 available for loans. This creates promise-to-pay money from a previous promise-to-pay, inflating the M1 money supply (M1=$2,439). Mandy's bank now lends the money to someone else who deposits it in a checking account at another bank, and the process repeats itself.