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Definition, Measurement
& Functions of Money

Explore what money is, why it matters, how we measure the money supply, and the essential functions that make modern economies work.

AP Macroeconomics

What Is Money?

Money is any asset that is widely accepted as a medium of exchange in transactions for goods and services. It is not simply cash: money includes anything a society agrees can settle debts and purchase goods.

The Three Functions of Money

Medium of Exchange
Money eliminates the need for a double coincidence of wants by serving as an intermediary in all transactions.
Unit of Account
Money provides a common measure of value so we can compare the prices of different goods and services.
Store of Value
Money allows people to transfer purchasing power from the present to the future by saving.

Why Money Matters

Without money, economies rely on barter: the direct exchange of goods for goods. Barter requires a double coincidence of wants: both parties must desire exactly what the other has to offer.

Barter Economy Farmer has wheat Needs shoes Must find a shoemaker who wants wheat! ✕ Inefficient Money Economy Farmer sells wheat for money Uses money to buy shoes from anyone ✓ Efficient

Commodity vs Fiat Money

Commodity Money Fiat Money
Intrinsic Value Yes: the item has value on its own No: value comes from government decree
Examples Gold, silver, salt, cattle U.S. dollar, euro, yen
Backing Backed by the commodity itself Backed by public trust and legal tender laws
Supply Control Limited by physical supply Controlled by the central bank

Properties of Good Money

1
Durability: It must withstand repeated use without deteriorating.
2
Portability: Easy to carry and transfer from one person to another.
3
Divisibility: Can be divided into smaller units to make change.
4
Uniformity: Each unit must be identical in quality and value.
5
Limited Supply: Must be scarce enough to maintain its value over time.
6
Acceptability: Widely recognized and accepted as payment.

Measuring the Money Supply

The Federal Reserve tracks the money supply using different measures based on liquidity: how quickly an asset can be converted to cash without losing value.

M2 M1 Currency in circulation Demand deposits (checking) Traveler's checks Other checkable deposits Savings deposits Money market funds Small time deposits (< $100,000)

\( M1 \): The Most Liquid Money

\( M1 \) includes the most liquid forms of money: assets that can be used immediately for transactions without conversion.

Currency
Physical coins and paper bills held by the public (not in bank vaults).
Demand Deposits
Checking account balances that can be withdrawn on demand.
Other Checkable
Includes NOW accounts, ATS accounts, and credit union share drafts.

\( M2 \): The Broader Measure

\( M2 \) includes everything in \( M1 \) plus near-money assets that are slightly less liquid but easily convertible to cash.

1
Savings deposits: Earn interest, withdrawals may be limited, but funds are accessible.
2
Small time deposits: CDs under \( \$100{,}000 \) with fixed maturity dates. Early withdrawal triggers a penalty.
3
Money market mutual funds: Pooled investments in short-term securities. Highly liquid but not checkable.

The Liquidity Spectrum

Most Liquid Least Liquid Cash Checking (M1) Savings (M2) CDs (M2) Real Estate (Not money)

\( M1 \) vs \( M2 \): Key Distinction

\( M1 \) \( M2 \)
Definition Most liquid money \( M1 \) + near-money
Includes Cash, checking, traveler's checks + Savings, small CDs, money market
Can Spend Immediately? Yes Usually needs conversion
Size (U.S., approx.) \( \sim\$4.5 \) trillion \( \sim\$21 \) trillion
Fed Uses For Transaction money tracking Broader economic analysis

How to Classify an Asset

1
Ask: Can I spend it directly? If yes, it belongs in \( M1 \) (cash, checking accounts).
2
Ask: Can I easily convert it to cash? If yes with minimal penalty, it belongs in \( M2 \) (savings, small CDs, money market).
3
Ask: Is it a loan or line of credit? If yes, it is not money at all (credit cards, mortgages).
4
Ask: Is it illiquid? Stocks, bonds, and real estate are not part of \( M1 \) or \( M2 \).

Example: Classifying Assets

Jamal has the following assets. Classify each as \( M1 \), \( M2 \) only, or neither:

\( \$500 \) in his wallet
\( M1 \): Physical currency held by the public is the most liquid asset.
\( \$2{,}000 \) in savings
\( M2 \) only: Savings deposits are near-money, easily converted but not directly spendable.
\( \$3{,}000 \) in checking
\( M1 \): Demand deposits can be accessed immediately via debit card or check.

Example: Trickier Assets

Visa credit card
Neither \( M1 \) nor \( M2 \): A credit card is a short-term loan, not an asset you own.
\( \$5{,}000 \) CD (6-month)
\( M2 \) only: Small time deposit under \( \$100{,}000 \). Penalty for early withdrawal.

Example: Computing \( M1 \) and \( M2 \)

Given the following data for a hypothetical economy, compute \( M1 \) and \( M2 \):

Asset Amount (billions)
Currency in circulation\( \$800 \)
Demand deposits\( \$1{,}200 \)
Savings deposits\( \$2{,}500 \)
Small time deposits\( \$600 \)
Money market funds\( \$400 \)

Common Mistakes

✕ Credit Cards Are Money
Credit cards are loans, not assets. They are neither in \( M1 \) nor \( M2 \). Debit cards access checking (which is \( M1 \)).
✕ Confusing \( M1 \) and \( M2 \)
\( M2 \) includes all of \( M1 \). Savings deposits are in \( M2 \) but not in \( M1 \). Don't double count.
✕ Stocks and Bonds Are Money
Stocks, bonds, and real estate are financial assets but are not part of the money supply. They are too illiquid.

Question 1 of 5

Which of the following is NOT a function of money?

Question 2 of 5

A \( \$10{,}000 \) balance in a savings account is included in:

Question 3 of 5

Which of the following best explains why credit cards are not considered part of the money supply?

Question 4 of 5

An economy has \( \$600 \) billion in currency, \( \$900 \) billion in demand deposits, \( \$1{,}400 \) billion in savings deposits, and \( \$300 \) billion in small time deposits. What is \( M2 \)?

Question 5 of 5

U.S. dollars are an example of fiat money because they: