4.3 - Definition, Measurement, and Functions of Money
Why Money Matters
Money might be one of the greatest inventions ever, because it makes trade so much easier. It’s defined as any asset accepted as payment, which includes cash and bank deposits. Without money, you’re stuck with barter, and barter is a pain because it requires a “coincidence of wants,” meaning you have to find someone who has what you want and also wants what you have.
Money serves three functions:
- Medium of exchange: people accept money for goods and services because they know they can turn around and use it to buy something else.
- Unit of account: money lets you easily compare the value of different goods, services, and labor.
- Store of value: money holds its value over time, though inflation chips away at this. Quick tip: if a question is about saving or holding money over time, the answer is almost always “store of value.”
Types of Money
- Commodity money: the original type of money. It has real value on its own, separate from being used as money. Think gold, silver, or even cigarettes used as currency in prisons.
- Commodity-backed money: paper money that represents a set amount of some commodity, like gold or silver. It’s easier to carry around than the commodity itself, and people trust it because they know they could trade it in for the real thing.
- Fiat money: what the U.S. and most developed countries use today. It’s money because the government says it’s money. There’s no commodity backing it up, just the “full faith and credit” of the government. It works because people believe others will accept it, and you’re required to use it to pay taxes. Sometimes people call it “faith-based money.”
Measuring the Money Supply
- M1 (narrow): the most liquid assets (cash in circulation, demand deposits, and savings deposits).
- M2 (broad): all of M1, plus slightly less liquid stuff like time deposits and money market funds. These extras are called “near monies” since they’re not spendable directly but can quickly convert into cash.
- Monetary base (M0): currency in circulation plus bank reserves (the money banks are holding onto instead of lending out). Both the money supply and the monetary base include currency in circulation, but the money supply also counts demand deposits, while the monetary base counts bank reserves instead.
Calculating M1, M2, and the Monetary Base
AP questions often give you a list of amounts and ask you to add up the right ones. Say an economy has:
Item | Amount |
Currency in circulation (cash held by the public) | $300 billion |
Demand deposits (checking accounts) | $500 billion |
Savings deposits | $1,200 billion |
Small time deposits (CDs) | $400 billion |
Money market funds | $600 billion |
Bank reserves | $700 billion |
- M1 = currency in circulation + demand deposits + savings deposits = $300 + $500 + $1,200 = $2,000 billion.
- M2 = M1 + time deposits + money market funds = $2,000 + $400 + $600 = $3,000 billion.
- Monetary base = currency in circulation + bank reserves = $300 + $700 = $1,000 billion.
Bank reserves don’t count in M1 or M2, since that money is held by banks, not the public. The same goes for cash sitting in a bank’s vault: it counts as reserves, not as currency in circulation.
Moving money around only changes a measure if the money moves into or out of it:
- Depositing $100 of cash into checking: currency falls $100 and demand deposits rise $100, so M1 and M2 don’t change. (The bank does get $100 of new reserves, which is how lending starts in 4.4.)
- Moving $100 from checking to savings: both are part of M1, so M1 and M2 don’t change.
- Moving $100 from savings into a CD: M1 falls by $100, but M2 doesn’t change, since the CD is still part of M2.
Heads up: the Fed has counted savings deposits in M1 since 2020. Older books and practice questions may list savings deposits only under M2.
Bottom line: money’s defining feature is acting as a medium of exchange, which solves the barter problem. Today we use fiat money, backed only by trust. Economists track the money supply using M1 (cash, checking, savings) and the broader M2 (M1 plus near monies).