Definition, Measurement, and Functions of Money: Study Guide (Macroeconomics 4.3)

What money is

In everyday speech, “money” often means wealth or income: “she makes a lot of money”. Economists use the word more narrowly.

Money is any asset that people accept as a means of payment. If a shop, a worker or a landlord will take it in exchange for goods, services or debts, it is money.

Money is only one of the assets people can hold. In Topic 4.1 you met bonds and stocks. They can store wealth and may earn a return, but you cannot pay for groceries with a bond. To spend it, you must first sell it for money. This is why money is the most liquid asset: it can be used to buy things straight away, with no loss of value.

Without money, people would have to barter: swap goods directly for other goods. Barter needs a double coincidence of wants. A tailor who wants rice must find a rice farmer who wants a shirt, at the same time. Money removes this problem. The tailor sells shirts to anyone for money, then uses the money to buy rice from anyone.

The three functions of money

Anything that works well as money does three jobs.

Function	What it means	Valdorian example
Medium of exchange	It is accepted in payment for goods and services	A student pays VD 6 for lunch with a banknote
Unit of account	Prices and values are measured in it, so they can be compared	A shop labels a jacket VD 45 and a scarf VD 15, so you see at once that the jacket costs three scarves
Store of value	It holds purchasing power over time, so you can spend it later	A farmer keeps part of this month’s sales revenue to pay for seed next spring

How to identify the function from an example. Ask what money is doing in the example.

• Something is being bought or paid for → medium of exchange.
• Values are being stated, recorded or compared in money terms (price tags, menus, accounts, a debt written as “VD 500”) → unit of account.
• Money is being kept to spend later → store of value.

Money is an imperfect store of value. Inflation reduces what money can buy. If Valdoria’s prices rise by 5% in a year, VD 100 kept in a drawer buys only 100 ÷ 1.05 = VD 95.24 worth of this year’s goods next year. Other assets, such as bonds, may store value better, because they pay interest. That interest is the opportunity cost of holding money (Topic 4.1). People still hold money because it is the only asset that works directly as a medium of exchange.

Measuring the money supply: M1 and M2

The money supply is the total quantity of money in the economy. Central banks measure it with monetary aggregates, which group assets by how liquid they are. The course uses two: M1 and M2.

M1 holds the most liquid forms of money: the assets you can spend immediately.

• Currency in circulation: banknotes and coins held by the public (households and firms), outside banks and the central bank.
• Demand deposits (also called checkable deposits): balances in checking (current) accounts that you can spend by debit card, cheque or bank transfer.

M2 adds near-money: assets that are slightly less liquid but can be turned into M1 quickly and with little or no loss.

• Savings deposits: bank accounts that pay interest and are easy to move into checking.
• Small time deposits: deposits held for a fixed period, such as certificates of deposit (CDs). There is usually a penalty for withdrawing early.
• Retail money market funds: funds that hold short-term, low-risk securities and that households can withdraw from quickly.

So:

M1 = currency in circulation + demand (checkable) deposits

M2 = M1 + savings deposits + small time deposits + retail money market funds

M2 always includes everything in M1, so M2 is always larger than M1.

Not money: stocks, bonds, houses and other assets that must be sold first; large time deposits held by institutions; and credit cards. A credit card is a way of borrowing. The money is paid later, usually from a demand deposit, and it is that deposit that counts in M1.

Background (real-world note). Official definitions differ between countries and change over time. In the United States, the Federal Reserve has counted savings deposits in M1 since 2020. This guide uses the definitions above, where savings deposits are in M2 but not M1. If a question gives its own definitions, use the ones it gives.

The monetary base

The monetary base (often written MB or M0) is the money created directly by the central bank. It has two parts:

Monetary base = currency in circulation + bank reserves

Bank reserves are the funds banks hold as cash in their vaults or as deposits at the central bank. Reserves are counted in the monetary base, but they are not in M1 or M2. Banknotes in a bank’s vault are not “in circulation”. Currency in circulation is the only item that appears in both M1 and the monetary base.

The monetary base matters in Topic 4.4: banks use their reserves to make loans, and this expands the money supply to a multiple of the base.

Our fictional economy: Valdoria

Valdoria is the fictional country used across the Marlbridge macroeconomics pages. Its currency is the valda (VD). Its central bank uses the definitions in this guide. All figures are fictional, in billions of valdas.

Item	VD billion
Currency in circulation	120
Demand (checkable) deposits	300
Savings deposits	450
Small time deposits	180
Retail money market funds	90
Large time deposits held by institutions	200
Vault cash held by banks	25
Banks’ deposits at the central bank	45
Government bonds held by the public	600
Unused credit card limits	260

Worked example 1: calculating M1, M2 and the monetary base

Question. Use the Valdoria table. Calculate (a) M1, (b) M2 and (c) the monetary base. (d) How much of M2 is near-money?

(a) M1 = currency in circulation + demand deposits = 120 + 300 = VD 420 billion.

Do not add vault cash or banks’ deposits at the central bank. They are reserves, not money held by the public. Adding them would give 490, which is wrong.

(b) M2 = M1 + savings deposits + small time deposits + retail money market funds = 420 + 450 + 180 + 90 = VD 1,140 billion.

Leave out the large time deposits (not in M2 under these definitions), the government bonds (they must be sold before they can be spent) and the unused credit card limits (borrowing, not money). Adding the large time deposits would give 1,340.

(c) Bank reserves = vault cash + deposits at the central bank = 25 + 45 = VD 70 billion. Monetary base = currency in circulation + reserves = 120 + 70 = VD 190 billion.

(d) Near-money = M2 − M1 = 1,140 − 420 = VD 720 billion. So M1 is 420 ÷ 1,140 × 100 = 36.84% of M2.

Check. M2 (1,140) is larger than M1 (420), as it must be. Currency (120) is counted in both M1 and the monetary base.

Worked example 2: how transactions change the measures

Moving money between kinds of accounts does not create or destroy wealth, but it can change M1. The trick is to ask: which category does the money leave, and which does it enter?

Question. Start from the Valdoria figures (M1 = 420, M2 = 1,140, MB = 190). The following happen one after another. After each, find M1, M2 and the monetary base.

(a) Households move VD 5 billion from checking accounts into small time deposits. Demand deposits fall from 300 to 295 (M1 falls). Small time deposits rise from 180 to 185 (in M2 but not M1). The money stays inside M2. M1 = 120 + 295 = 415. M2 = 1,140 (unchanged). MB = 190 (unchanged: no currency or reserves moved).

(b) Firms deposit VD 2 billion of banknotes into their checking accounts. Currency in circulation falls from 120 to 118. Demand deposits rise from 295 to 297. The banknotes are now in bank vaults, so reserves rise from 70 to 72. M1 = 118 + 297 = 415 (unchanged: money changed form, not amount). M2 = 1,140. MB = 118 + 72 = 190 (unchanged: currency fell, reserves rose by the same amount).

(c) Households withdraw VD 3 billion in cash from savings accounts. Savings deposits fall from 450 to 447. Currency in circulation rises from 118 to 121. Banks pay out the cash from their vaults, so reserves fall from 72 to 69. M1 = 121 + 297 = 418 (up by 3: money moved from near-money into currency). M2 = 418 + 447 + 185 + 90 = 1,140 (unchanged). MB = 121 + 69 = 190 (unchanged).

(d) One household buys VD 4 billion of existing government bonds from another household, paying by bank transfer. The buyer’s demand deposits fall by 4 and the seller’s rise by 4. Total demand deposits stay at 297. M1 = 418, M2 = 1,140, MB = 190. Nothing changes: money only changed hands.

Summary. Over the four steps, M1 fell by 2 (−5 + 0 + 3 + 0), while M2 and the monetary base did not change. None of these transactions created new money. In Topic 4.4 you will see what does: bank lending.

Common misconceptions

• “Money means wealth or income.” In economics, money is only the assets accepted as a means of payment. A rich person’s house is wealth but not money.
• “A credit card is money.” It is a short-term loan. The debt is settled later with money.
• “M1 and M2 are separate, so add them to get the money supply.” M2 already contains M1. Adding them double-counts M1.
• “Bank reserves are part of M1.” Cash inside banks and banks’ deposits at the central bank are reserves. They are in the monetary base, not in M1 or M2.
• “Depositing cash in a bank increases the money supply.” Currency falls and deposits rise by the same amount, so M1 and M2 do not change.
• “Moving funds from checking to savings or a time deposit reduces M2.” It reduces M1 but leaves M2 unchanged, because the money moves within M2.
• “Prices written in valdas show money as a medium of exchange.” Stating or comparing prices is the unit of account function. Medium of exchange needs an actual payment.
• “Money is a perfect store of value.” Inflation erodes its purchasing power, and holding money means giving up the interest other assets would earn.

Where this leads

Next, Topic 4.4 shows how banks use their reserves to make loans and so expand the money supply beyond the monetary base: see Banking and the Expansion of the Money Supply. Before moving on, try the practice questions, then use the revision notes and the checklist to consolidate. If liquidity or the opportunity cost of holding money is unclear, review Topic 4.2, Nominal v. Real Interest Rates and Topic 4.1, Financial Assets.