AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/4/4-3)
Unit 4 · Topic 4.3
4.3 Definition, Measurement, and Functions of Money
Money is anything people widely accept as payment, and it does three jobs: medium of exchange, unit of account and store of value. The Federal Reserve measures the money supply with M1 and M2, which differ in how liquid their parts are. The monetary base, currency plus bank reserves, is measured separately.
Key terms
- medium of exchange
- unit of account
- store of value
- M1
- M2
- monetary base
What makes something money
Money is any asset that people generally accept as payment for goods, services and debts. Without it, you'd have to barter, trading goods directly. Barter only works when each side happens to have what the other wants, which economists call a double coincidence of wants.
The U.S. dollar is fiat money: it has value because the government declares it legal tender and people trust that others will accept it, not because the paper is worth anything.
A credit card isn't money. Paying with one is taking out a short-term loan; money changes hands later, when you pay the bill. A debit card isn't money either. It's a way to move the money in your checking account, and that account is the money.
The three functions of money
On the exam, you may need to match an example to its function. Ask yourself: is money being spent, used to compare values, or saved?
- Medium of exchange: you use it to buy things. Example: paying $6 for lunch.
- Unit of account: prices are stated in it, so you can compare values. Example: seeing that a $30 shirt costs five times as much as a $6 lunch.
- Store of value: it holds purchasing power over time. Example: saving $20 from a paycheck to spend next month. High inflation weakens this job, because money buys less as time passes.
Measuring the money supply: M1 and M2
The money supply is measured with groups called monetary aggregates. The Federal Reserve (the Fed, the central bank of the U.S.) publishes two: M1 and M2.
M1 is part of M2, so M2 is always larger. A note on savings deposits: since May 2020, the Fed has counted them in M1, because people can now move and spend them almost as easily as checking deposits. Many textbooks and older videos still put savings deposits only in M2. M2 is the same under either definition. If a question gives its own definition, use it.
| Measure | What it includes | How liquid |
|---|---|---|
| M1 | Currency in circulation, checkable (demand) deposits and savings deposits | The most liquid money |
| M2 | Everything in M1, plus small time deposits (such as CDs under $100,000) and retail money market funds | Adds near-monies that are a little harder to spend |
The monetary base
The monetary base (written MB or M0) is the narrowest measure: currency in circulation plus bank reserves. Reserves are the cash banks keep in their vaults plus the deposits banks hold at the central bank.
The central bank controls the monetary base directly. When it buys bonds, it pays by adding to banks' reserves, so the base grows. Through bank lending, the money supply can then grow by more than the base did (4.4).
Moving money between kinds of accounts can change one measure but not another. If you deposit $100 of cash into checking, currency in circulation falls $100 and checkable deposits rise $100, so M1 doesn't change. The monetary base doesn't change either: currency falls $100 and bank reserves rise $100. What changes is that the bank now has new reserves it can lend.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Calculating M1, M2 and the monetary base
An economy has the following, in billions of dollars: currency in circulation, 2,000; checkable deposits, 3,000; savings deposits, 9,000; small time deposits, 1,000; retail money market funds, 1,100; bank reserves, 3,500. Using the Fed's current definitions, find M1, M2 and the monetary base.
Show the solutionHide the solution
- Step 1: M1 = currency + checkable deposits + savings deposits = 2,000 + 3,000 + 9,000 = 14,000.
- Step 2: M2 = M1 + small time deposits + retail money market funds = 14,000 + 1,000 + 1,100 = 16,100.
- Step 3: Monetary base = currency in circulation + bank reserves = 2,000 + 3,500 = 5,500. Deposits are not part of the base.
- Step 4: Under the older definition (savings deposits in M2 only), M1 would be 2,000 + 3,000 = 5,000, but M2 would still be 16,100.
Answer: M1 = $14,000 billion; M2 = $16,100 billion; monetary base = $5,500 billion.
- Example 2
Which function is it?
Name the function of money in each case. (a) A store tags a jacket at $80. (b) You keep $200 in a drawer to spend on a trip next summer. (c) You hand a cashier $5 for a sandwich.
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- Step 1: (a) The price tag measures the jacket's value in dollars, so you can compare it with other goods: unit of account.
- Step 2: (b) You're holding purchasing power to use later: store of value.
- Step 3: (c) You're using money to buy something: medium of exchange.
Answer: (a) Unit of account. (b) Store of value. (c) Medium of exchange.
- Example 3
Moving money between accounts (classic trap)
Jordan moves $1,000 from a checking account into a one-year certificate of deposit (CD), which is a small time deposit. Using the Fed's current definitions, what happens to M1 and M2?
Show the solutionHide the solution
- Step 1: Checkable deposits are in both M1 and M2, so this side of the move lowers M1 by $1,000 and lowers M2 by $1,000.
- Step 2: Small time deposits are in M2 but not M1, so the CD raises M2 by $1,000 and doesn't affect M1.
- Step 3: Net effect: M1 falls by $1,000. M2 is unchanged, because the money just moved from one part of M2 to another.
- Step 4: The trap is assuming both measures must move together. They only do if money enters or leaves both.
Answer: M1 falls by $1,000; M2 doesn't change.
Common mistakes
- Counting credit cards as money. A credit card purchase is a loan; only the later payment from your account uses money.
- Treating M1 and M2 as separate piles. M2 includes all of M1, so M2 is always at least as big as M1.
- Saying a cash deposit into checking increases M1. It only changes the form the money takes; M1 stays the same until banks lend out the new reserves.
- Mixing up the monetary base with M1. The base is currency in circulation plus bank reserves; it doesn't include checking or savings deposits.
On the exam
- Expect multiple-choice questions that ask which function of money an example shows, or how moving funds between accounts changes M1 and M2.
- Free-response questions may give account data and ask you to calculate a money measure or the monetary base. Add only the parts that belong in that measure, and show the sum.
Connected topics
Videos
Check yourself
4 questions on 4.3 Definition, Measurement, and Functions of Money. Pick an answer to see if you got it, and why.
A restaurant lists the prices of all its dishes in dollars, so customers can easily compare a $9 salad with a $14 pasta. Which function of money does this illustrate?
A teenager puts $200 of birthday money in a drawer to spend next summer. Which function of money is the teenager relying on?
In a barter economy, a farmer who wants shoes must find a shoemaker who wants the farmer's wheat. Which function of money most directly removes this problem?
Which of the following is included in M2 but not in M1?
0 of 4 answered