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AP® Macroeconomics · Unit 4 · Topic 4.3

Definition, Measurement, and Functions of Money: Revision Notes (Macroeconomics 4.3)

One-page recap of what money is, its three functions, and how to calculate M1, M2 and the monetary base, with the classification mistakes that cost marks.

Short on time? This page is the recap. For explanations and worked examples, use the full study guide.

Recap

  • Money is any asset accepted as a means of payment. It is the most liquid asset.
  • Money solves the double coincidence of wants problem of barter.
  • Functions: medium of exchange (used to pay), unit of account (used to state and compare values), store of value (used to hold purchasing power for later).
  • Inflation weakens money as a store of value; holding money also means giving up interest.
  • Monetary aggregates measure the money supply, grouped by liquidity: M1 and M2.
  • The monetary base is currency in circulation plus bank reserves.

Key relationships

Measure What it includes Not included
M1 Currency in circulation + demand (checkable) deposits Reserves, savings, time deposits
M2 M1 + savings deposits + small time deposits + retail money market funds Large time deposits, bonds, stocks, credit limits
Monetary base Currency in circulation + bank reserves (vault cash + deposits at the central bank) Demand deposits, savings
Near-money M2 − M1 —

Assumptions behind the numbers

  • These are the course’s standard definitions. Real-world definitions vary by country and over time (in the United States, savings deposits have been in M1 since 2020). If a question states its own definitions, use them.
  • Currency “in circulation” means held by the public, outside banks and the central bank.

Mistakes to avoid

  1. Adding M1 to M2. M2 already includes M1.
  2. Counting reserves in M1. Vault cash is not in circulation.
  3. Counting credit cards as money. They are a way to borrow.
  4. Saying a cash deposit raises M1. Currency falls, deposits rise: no change.
  5. Saying checking-to-savings lowers M2. It lowers M1 only.
  6. Mixing up unit of account and medium of exchange. A price tag is a unit of account; a payment is a medium of exchange.

Quick self-check

All figures are fictional, in billions of valdas (VD), the currency of Valdoria.

  1. Currency in circulation 50, demand deposits 130, savings 200, small time deposits 40, retail money market funds 30, bank reserves 20. Find M1, M2 and the monetary base. (M1 = 180; M2 = 450; MB = 70)
  2. A diner’s menu lists every dish in valdas. Which function of money is shown? (Unit of account)
  3. A household moves VD 1,000 from its checking account to a certificate of deposit. What happens to M1 and M2? (M1 falls by VD 1,000; M2 is unchanged)

Next: practice questions.

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