4.3 The Definition, Measurement, and Functions of Money

What Money Does

Money is anything widely accepted as payment for goods and services. It serves three key functions: a medium of exchange (used to buy/sell things, avoiding barter), a unit of account (a common measure to price goods), and a store of value (holds purchasing power over time so it can be saved and used later).

Measuring the Money Supply

Economists measure money using M1 and M2. M1 includes the most liquid assets: currency in circulation, checkable deposits, and traveler's checks. M2 is broader — it includes everything in M1 plus less liquid, near-monies like savings deposits, small time deposits (CDs under $100,000), and money market mutual funds.

Liquidity Spectrum

Liquidity is how quickly and easily an asset converts to cash without losing value. Cash is perfectly liquid; assets like real estate or stocks are less liquid. M1 assets are more liquid than the additional assets in M2, which is why M1 is a subset of M2.

Key terms

Medium of exchange

A function of money where it is accepted as payment for goods and services, avoiding the need for barter.

Unit of account

A function of money that provides a common measure to express the value/price of goods and services.

Store of value

A function of money that lets it retain purchasing power over time, so it can be saved and used later.

M1

The narrowest measure of money supply: currency in circulation, checkable deposits, and traveler's checks.

M2

M1 plus less liquid near-monies: savings deposits, small time deposits, and money market mutual funds.

Try an AP-style question

Which is included in M1?

1. Checking account balances
2. Stocks
3. Money market funds
4. Savings accounts