Money can take several forms. In AP Macroeconomics, money is defined as any asset that is accepted as a means of payment. One form is what we call fiat money. Fiat money is something that serves as money or currency and has no other important uses. Examples of fiat money include our paper money and coins. Another form of money is called commodity money. Commodity money is something that performs the function of money and has an alternative, non-monetary use. Some examples are gold, silver, oil, precious metals, and tobacco.
Functions of Money
Money is any asset that is accepted as a means of payment. Money serves three main functions: it acts as a medium of exchange, a unit of account, and a store of value.
There are various examples of each of the functions.
Medium of Exchange
Money must always be able to be easily transacted. If you want to buy apples, you should be able to at the local grocery store without much problem. In a sense, it's a convenient way to exchange what you have for what the grocery store has. Think of getting paid. It's also an efficient way to get rewarded for your work without creating a hassle about what you should get.
Look at the image below. How do you know if your goat is worth the same as a lamb? Should you get a lamb in return for your goat? Is it a fair trade? What if goats are more valuable? How do you know what to add to the trade in order to make it a fair one? With money, everything's laid out, no problems in buying or selling, whether it's a good or labor.
Unit of Account
It also has to be able to show value. How do you know if cheese is more valuable than eggs? How do you know if diamonds are more valuable than a pencil? Usually, we look at the price. If the price of a diamond is higher than a pencil, you know it's more valuable.
Or think about a house? How do you know if your house is more valuable than the house across the street? Money (or price) sets a value that everyone can understand. It's almost a universal measurement system of value.
Store of Value
Lastly, we have a store of value. Store of value means money can hold purchasing power over time, allowing people to save and use it later, although inflation can reduce its real value. If you hide your $20 allowance under your bed, chances are, it'll still hold its value the next week or even the next year. If you hide your favorite Oreos under your bed, after a month, it won't hold its original value of being an awesome delicious cookie. Instead, it'll just be a piece of baked flour with moldy cream in between.
Examples:
- A high school senior depositing part of a paycheck into a savings account is an example of money serving as a store of value because the money can be saved and used later.
- An example of the unit of account function is when a name-brand good is twice as expensive as a similar, generic good.
- A retired couple spending $9000 on a month-long European vacation is an example of the function: medium of exchange.
Measurements of the Money Supply
Different types of money are placed into categories based on what they include, their liquidity, and what function they typically perform. Liquidity refers to how easily something can be converted to cash. Surprisingly, one thing that is not considered money is a credit card. A credit card is actually a short-term loan with excessive interest rates. The money supply is measured using monetary aggregates, especially M1 and M2.
- M1 = cash + checkable deposits + savings accounts
- M2 = M1 + certificates of deposit + money market mutual fund shares
M1 and M2 are two different measures of the money supply, and M2 includes all of M1 plus additional near-money assets.
Calculating M1, M2, and the Monetary Base
Being able to calculate these measures from data is an important skill. Here's an example:
Example: Suppose an economy has $500 billion in cash, $1,200 billion in checkable deposits, $2,000 billion in savings accounts, $300 billion in certificates of deposit, and $400 billion in money market mutual fund shares.
- M1 = cash + checkable deposits + savings accounts = 1,200b + 3,700 billion**
- M2 = M1 + certificates of deposit + money market mutual fund shares = 300b + 4,400 billion**
If currency in circulation is $500 billion and bank reserves are $200 billion, then the monetary base (MB) = 200b = $700 billion.
Monetary Base
The monetary base (M0 or MB) refers to the money in circulation or in the bank reserves. The monetary base includes currency in circulation and bank reserves held at banks or at the central bank. The monetary base is not the same thing as the money supply. It includes currency in circulation, which is part of M1 and M2, plus bank reserves, which are not counted in M1 or M2. The monetary base is a measure of highly liquid money consisting of currency in circulation plus bank reserves. It is a stock of money, not a description of whether a particular purchase or debt payment counts as money.
Vocabulary
The following words are mentioned explicitly in the College Board Course and Exam Description for this topic.Term | Definition |
|---|---|
bank reserves | Money held by banks that is not loaned out, including reserves required by the Federal Reserve and excess reserves. |
currency in circulation | Physical money (coins and paper bills) that is in use by the public and businesses. |
M1 | A monetary aggregate that includes the most liquid forms of money, such as currency in circulation and checking accounts. |
M2 | A monetary aggregate that includes M1 plus less liquid assets such as savings accounts and money market accounts. |
measures of money | Quantitative calculations used to determine the money supply, including monetary aggregates such as M1 and M2. |
medium of exchange | A function of money that allows it to be used to purchase goods and services. |
monetary aggregates | Different measures of the money supply, including M1 and M2, that categorize money based on liquidity. |
monetary base | The total amount of money created by a central bank, consisting of currency in circulation and bank reserves. |
money | Any asset that is accepted as a means of payment for goods and services. |
money supply | The total amount of money available in an economy at a given time, including currency in circulation and deposits in financial institutions. |
store of value | A function of money that allows it to be saved and used to purchase goods and services in the future. |
unit of account | A function of money that provides a standard measure for comparing the value of different goods and services. |
Frequently Asked Questions
What is money exactly and how is it different from just any valuable thing?
Money is any asset people widely accept as a means of payment—that’s the AP definition (EK MEA-3.C.1). What makes money different from “something valuable” is acceptability and liquidity: money must work as a medium of exchange (you can buy stuff with it), a unit of account (prices are quoted in it), and a store of value (it keeps purchasing power over time) (EK MEA-3.C.2). Gold or a painting is valuable, but they’re not reliably accepted for everyday transactions and aren’t as liquid. Modern money is usually fiat money (legal tender by government decree) and measured by aggregates: M1 = currency + demand deposits + savings accounts; M2 = M1 + certificates of deposit and retail money market mutual fund shares (EK MEA-3.C.3). For AP review, see the Topic 4.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/definition-measurement-functions-money/study-guide/b7Tl6hHynHY8Nz1jEinl) and practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
What are the three functions of money and can you give me examples of each one?
Money has three functions (CED EK MEA-3.C.2): - Medium of exchange—used to buy/sell goods and services. Example: you pay $5 for a coffee with cash or debit; because people accept dollars, you don’t have to barter. This is key on the exam when they ask how money solves the double-coincidence-of-wants problem. - Unit of account—a common measure to set prices and record value. Example: stores list prices in dollars, so you can compare a $10 shirt to a $25 jacket. This ties to comparing relative prices and calculating real vs. nominal values. - Store of value—holds purchasing power over time. Example: keeping money in a savings account (near-money) so you can spend later; inflation can erode this function. Related AP topics: liquidity, M1 vs. M2, and interest rates. Want a quick review? See the Topic 4.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/definition-measurement-functions-money/study-guide/b7Tl6hHynHY8Nz1jEinl) and practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
How do I calculate M1 and M2 money supply if I'm given data about checking accounts and savings?
M1 includes the most liquid money: currency + demand deposits/checking accounts + savings accounts. If you are given checking and savings only, both belong in M1 under the current Fed definition. Example: checking = $500 and savings = $1,200 → M1 = $1,700. M2 includes all of M1 plus less liquid near-money assets such as certificates of deposit/time deposits and retail money market mutual fund shares. On the AP, be clear which aggregate the question asks for and show your arithmetic (CED EK MEA-3.C.3). For more review on definitions and examples, see the Topic 4.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/definition-measurement-functions-money/study-guide/b7Tl6hHynHY8Nz1jEinl), Unit 4 overview (https://library.fiveable.me/ap-macroeconomics/unit-4), and AP macro practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
I'm confused about the difference between M1 and M2 - which one includes what?
M1 is the narrow, most liquid measure of money: currency in circulation (paper money and coins), demand/checkable deposits, and savings accounts under the current Fed definition. M2 is broader: it includes all of M1 plus less liquid near-money assets such as certificates of deposit/time deposits and retail money market mutual fund shares. M1 focuses on money that can be used for payments; M2 adds store-of-value assets that are still relatively easy to convert. On the exam, you’ll be asked to identify or calculate these aggregates (Topic 4.3, EK MEA-3.C.3). For a quick review, see the Topic 4.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/definition-measurement-functions-money/study-guide/b7Tl6hHynHY8Nz1jEinl), the Unit 4 overview (https://library.fiveable.me/ap-macroeconomics/unit-4), and practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
What's the monetary base and how is it different from M1 and M2?
The monetary base (MB or M0) is the narrowest measure of money: currency in circulation plus banks’ reserves held at the central bank (including vault cash). It’s what the Fed directly controls through tools like open-market operations and interest on reserves. M1 is broader than MB for practical spending: currency plus demand/checkable deposits and savings accounts under the current Fed definition. M2 is broader still: M1 plus certificates of deposit/time deposits and retail money market mutual fund shares. Key AP links: the CED treats MB as currency plus reserves (EK MEA-3.C.4) and defines M1/M2 as monetary aggregates (EK MEA-3.C.3). For practice and calculations, see the Topic 4.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/definition-measurement-functions-money/study-guide/b7Tl6hHynHY8Nz1jEinl) and Unit 4 resources (https://library.fiveable.me/ap-macroeconomics/unit-4).
Why can't we just use gold or bitcoin as money instead of dollars?
Good question. Money has three jobs: medium of exchange, unit of account, and store of value (CED EK MEA-3.C.2). Gold and bitcoin can serve some of those, but they fall short in important ways for a modern economy. Dollars are fiat money—widely accepted, divisible, stable in day-to-day value, and integrated into the payments system and legal-tender rules. Gold is durable and a store of value but is hard to use for everyday transactions (low portability, hard to divide) and can’t be easily expanded/contracted by the Fed to manage the money supply (M1/M2, monetary base). Bitcoin is portable and digital but too volatile and not universally accepted, so it’s a poor unit of account and risky as a short-term store of value. Those practical traits (acceptance, liquidity, price stability, and integration with banking/fractional-reserve systems) explain why we use dollars. For more on money definitions and aggregates, see the Topic 4.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/definition-measurement-functions-money/study-guide/b7Tl6hHynHY8Nz1jEinl) and Unit 4 overview (https://library.fiveable.me/ap-macroeconomics/unit-4). Practice problems: (https://library.fiveable.me/practice/ap-macroeconomics).
How do I know if something counts as money or not for the AP exam?
Short answer: something counts as money on the AP exam if people accept it as a means of payment—i.e., it’s a medium of exchange, a unit of account, and reasonably a store of value (CED EK MEA-3.C.1–3.C.2). Quick checklist for the exam: - Is it widely accepted to buy goods/services? If yes, it’s money. - Is it highly liquid and easy to spend? Liquidity matters for inclusion in M1 vs M2. - Is it an asset like stocks/bonds (not money) or a payment method (money)? What counts: - M1: currency (cash & coins), demand/checkable deposits, and savings accounts under the current Fed definition. - M2: M1 plus certificates of deposit/time deposits and retail money market mutual fund shares. What doesn’t count: - Stocks, bonds, most commodities, and credit cards (credit card = loan, not money). - The monetary base (M0/MB) is currency in circulation + bank reserves (CED EK MEA-3.C.4)—a different measure. AP tip: be ready to identify items as M1, M2, or not money on multiple choice or free response. Review the Topic 4.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/definition-measurement-functions-money/study-guide/b7Tl6hHynHY8Nz1jEinl) and practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
What happens to the money supply when people move money from savings to checking accounts?
Under the current Fed definition, moving money from a savings account into a checking account does not increase M1 because savings accounts and checking accounts are both included in M1. It also does not change M2 because the money is only moving between components that are already included in M2. The monetary base (currency + reserves) isn’t affected unless you withdraw cash. This is a liquidity reclassification, not new money creation. Remember this distinction for AP Topic 4.3 (EK MEA-3.C.3)—exam questions often test M1 vs M2 differences. For a quick refresher, see the Topic 4.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/definition-measurement-functions-money/study-guide/b7Tl6hHynHY8Nz1jEinl) and practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
I don't understand how money serves as a store of value when inflation makes it worth less over time?
Money is a store of value because it holds purchasing power over time and is widely accepted (EK MEA-3.C.2, MEA-3.C.1). But inflation reduces that purchasing power—a real effect, not a contradiction. Example: with 3% inflation, $100 today will buy about $97 worth of goods a year from now (100/1.03 ≈ 97). How people deal with that: they don’t leave large sums as cash; they put money into interest-bearing assets (savings, short-term bonds) so the nominal interest offsets inflation. Remember the AP idea: real interest ≈ nominal interest − inflation (see Topic 4.2). Also, M1 is most liquid (currency, demand deposits) while M2 includes “near-money” (savings) that better preserves value (EK MEA-3.C.3). If you want practice applying this on the exam, review the Topic 4.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/definition-measurement-functions-money/study-guide/b7Tl6hHynHY8Nz1jEinl) and try problems at https://library.fiveable.me/practice/ap-macroeconomics.
Can you explain the difference between currency in circulation and bank reserves?
Currency in circulation = cash (coins + paper money) held by the public and businesses used as a medium of exchange (part of M1). Bank reserves = safe liquid funds banks hold as vault cash or on deposit at the Fed. Reserves aren’t in everyday spending; they’re used to meet reserve requirements and clear payments. The monetary base (MB or M0) = currency in circulation + bank reserves (CED EK MEA-3.C.4). In fractional-reserve banking, banks keep required reserves and may hold excess reserves; lending out the rest creates deposits and expands M1/M2 via the money multiplier. For AP exam practice, this shows up in money-supply and banking questions—know definitions, how reserves vs currency affect the monetary base, and how changes in reserves influence lending (see Topic 4.3 study guide: https://library.fiveable.me/ap-macroeconomics/unit-4/definition-measurement-functions-money/study-guide/b7Tl6hHynHY8Nz1jEinl; unit overview: https://library.fiveable.me/ap-macroeconomics/unit-4). For more practice problems, try https://library.fiveable.me/practice/ap-macroeconomics.
If M1 is $2 trillion and M2 is $15 trillion, what does that tell us about the economy?
If M1 = $2T and M2 = $15T, that tells you the broader money stock includes a large amount of less liquid near-money assets beyond M1, such as certificates of deposit/time deposits and retail money market mutual fund shares. In AP terms: M1 is the most liquid aggregate, while M2 is broader because it includes M1 plus additional store-of-value assets. That may imply greater use of interest-bearing savings instruments or money market funds. For monetary policy, the Fed’s actions that change the monetary base or reserve conditions can affect both aggregates through the banking system, but M2 tells you more about overall liquidity available across both immediately spendable money and near-money assets. For more on definitions and practice, check the Topic 4.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/definition-measurement-functions-money/study-guide/b7Tl6hHynHY8Nz1jEinl) and practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
Why do economists measure money supply in different ways like M0, M1, and M2?
Economists use M0/MB, M1, and M2 because each measures different degrees of liquidity and helps answer different policy questions. M0 (monetary base) = currency in circulation + bank reserves (most basic, controlled by the Fed). M1 = currency + demand deposits/checking + savings accounts under the current Fed definition. M2 = M1 plus certificates of deposit/time deposits and retail money market mutual fund shares. Using multiple aggregates shows how much immediately spendable money exists versus money that is less liquid but still close to money, which matters for the money multiplier, fractional-reserve banking, and predicting how monetary policy will affect interest rates, AD, and inflation. For AP review, know the definitions and be ready to calculate aggregates (CED EK MEA-3.C.3 and EK MEA-3.C.4). Want more examples and practice problems? See the Topic 4.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/definition-measurement-functions-money/study-guide/b7Tl6hHynHY8Nz1jEinl), the Unit 4 overview (https://library.fiveable.me/ap-macroeconomics/unit-4), and practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
What's the difference between money as a medium of exchange versus a unit of account?
Think of the difference like this: as a medium of exchange, money is what you use to make transactions—you hand over dollars to buy coffee. This role removes the need for barter and makes trading efficient (EK MEA-3.C.1–3.C.2). As a unit of account, money is the common yardstick used to price and compare goods and services—the coffee costs $3, your phone costs $300, so you can compare value and do accounting, contracts, and bookkeeping in one consistent measure. Practical contrast: medium = the dollar bill you pay with; unit = the price tag or number that tells you how much something is worth. The AP CED expects you to name and explain these functions (EK MEA-3.C.2). For a quick topical review and practice, see the Topic 4.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/definition-measurement-functions-money/study-guide/b7Tl6hHynHY8Nz1jEinl) and more practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
How does the Federal Reserve control the monetary base and why does it matter?
The Fed controls the monetary base (MB = currency in circulation + bank reserves) mainly by changing reserves banks hold. Its main tools: open-market operations (buying securities adds reserves and increases MB; selling drains reserves), changing the discount rate (affects borrowing from the Fed), and changing reserve requirements or interest on reserves (IOR) which influence how much banks hold. Why it matters: MB sets the amount of high-powered money that, through fractional-reserve banking and the money multiplier, determines broader aggregates (M1/M2). So by altering MB the Fed influences money supply, short-term interest rates, aggregate demand, and inflation—key topics on the AP (see Topic 4.3 and 4.4 connections). For more review, check the Topic 4.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/definition-measurement-functions-money/study-guide/b7Tl6hHynHY8Nz1jEinl) and practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
I'm studying for the FRQ and need to know when to mention M1 vs M2 in my answers about money supply.
Use M1 when the FRQ is asking about the most liquid money used directly for transactions, including currency, demand/checkable deposits, and savings accounts under the current Fed definition. Use M2 when the FRQ concerns the broader money supply or less liquid interest-bearing instruments. Say M2 = M1 + certificates of deposit/time deposits + retail money market mutual fund shares. On FRQs: if they ask you to calculate the money supply, use whichever aggregate they name and show the components and arithmetic (CED expects you to calculate M1 and M2: EK MEA-3.C.3). If they ask about liquidity, payments, or monetary policy effects on spending, justify using M1; if they ask about broader liquidity or near-money assets, use M2. For practice, review the Topic 4.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/definition-measurement-functions-money/study-guide/b7Tl6hHynHY8Nz1jEinl) and try problems on the Unit 4 page (https://library.fiveable.me/ap-macroeconomics/unit-4) or the practice bank (https://library.fiveable.me/practice/ap-macroeconomics).