Unit 4 · Topic 4.3

Definition, Measurement, and Functions of Money

Money is whatever people accept as a medium of exchange, use as a unit of account and hold as a store of value.

Practice 1: Principles and Models

Part 1 · Hook

Why this matters

A dollar bill costs a few cents to print, and nothing backs it but trust. Yet a store hands you a sandwich for it, and you can save it for next year. People have used shells, salt, cigarettes and gold as money. What makes something money is not what it is made of but the jobs it does.

Part 2 · Before you start

What this builds on

Part 3 · Prerequisite check

Quick check before you start

1. What is liquidity?

  1. How easily an asset becomes money without losing value
  2. How much interest an asset pays
  3. How risky an asset is
  4. How many people own an asset
Show the answer

Liquidity is how easily an asset turns into spendable money at full value.

  • Correct: How easily an asset becomes money without losing value:
  • How much interest an asset pays:
  • How risky an asset is:
  • How many people own an asset:

2. Which of these is a financial asset?

  1. A share of stock
  2. A pizza
  3. A factory machine
  4. An hour of labor
Show the answer

A share of stock is a claim on a firm's future income; the others are goods or resources.

  • Correct: A share of stock:
  • A pizza:
  • A factory machine:
  • An hour of labor:

Part 4 · See it

See it first

Nested boxes. M1, inside M2, holds currency held by the public, checkable deposits and savings deposits, which the Federal Reserve has counted in M1 since May 2020. M2 adds small time deposits under 100,000 dollars and retail money market funds. A separate box lists what is not money: credit cards, stocks and bonds, and houses, cars and gold.
M1, the most spendable money, sits inside M2; credit cards, stocks and bonds are not money. LevlPrep original diagram.

Part 5 · Step by step

How it works, step by step

  1. Barter needs a double coincidence of wantspeople adopt one thing everyone accepts in trade: money as a medium of exchange
  2. Everyone accepts the same moneyprices are stated in it, so money becomes the unit of account
  3. Money keeps its buying power over timepeople can save it, so it works as a store of value, until high inflation erodes it

Part 6 · Key ideas

Key ideas

  • Money has three functions: medium of exchange (accepted in payment), unit of account (prices are stated in it) and store of value (it holds buying power over time).
  • Fiat money has value because the government declares it money and people accept it; commodity money, such as gold, is valued as a good.
  • M1 is currency held by the public, checkable deposits and other deposits you can withdraw at once. M2 adds small time deposits and retail money market funds.
  • Credit cards, stocks and bonds are not money: a card is a loan, and stocks and bonds must be sold for money first.

Part 7 · Misconception

A common mistake

The wrong idea: A credit card is money, because you can pay with it.

What actually happens: Paying by credit card is borrowing from the card issuer. The money is the checkable deposit or cash that later pays the bill.

Part 8 · Check yourself

Check yourself

Exam-style questions. Anything you miss goes into your review queue.

1. Which list names the three functions of money?

  1. Medium of exchange, unit of account, store of value
  2. Medium of exchange, source of interest, store of value
  3. Unit of account, store of value, source of credit
  4. Store of value, measure of output, medium of exchange
Show the answer

Money serves as a medium of exchange, a unit of account and a store of value.

  • Correct: Medium of exchange, unit of account, store of value: Right: money is used to pay, to measure value and to save.
  • Medium of exchange, source of interest, store of value: Paying interest is not a function of money; currency pays none.
  • Unit of account, store of value, source of credit: Credit is borrowing, not a function of money itself.
  • Store of value, measure of output, medium of exchange: Output is measured with GDP. The third function is unit of account.

2. Prices in a country rise 40% in one year. Which function of its money is hurt the most?

  1. Store of value
  2. Unit of account, because prices are no longer in dollars
  3. Medium of exchange, because stores refuse payment
  4. Liquidity, because money takes longer to spend
Show the answer

High inflation erodes the buying power of money held over time, weakening it as a store of value.

  • Correct: Store of value: Right: money held for a year buys far less, so people stop holding it as savings.
  • Unit of account, because prices are no longer in dollars: Prices are still stated in the currency; they rise often.
  • Medium of exchange, because stores refuse payment: People still pay with it, often faster than before, to spend it before it loses value.
  • Liquidity, because money takes longer to spend: Money can still be spent at once; it is its value over time that suffers.

3. Why is a credit card not counted as money?

  1. It is not accepted in enough stores and online shops
  2. Paying with it is a loan, repaid later with money
  3. It earns interest for the cardholder
  4. Its value changes with stock prices
Show the answer

A credit card is a way to borrow. The checkable deposit or currency used to pay the bill is the money.

  • It is not accepted in enough stores and online shops: Credit cards are widely accepted; the issue is what paying with one is.
  • Correct: Paying with it is a loan, repaid later with money: Right: the card creates a debt to the card issuer; the money is what pays off the bill.
  • It earns interest for the cardholder: Credit cards charge the holder interest; they do not pay it.
  • Its value changes with stock prices: A card's use does not depend on stock prices; it is a way to borrow.

4. Ana moves $1,000 from her checking account into a one-year certificate of deposit. What happens to M1 and M2?

  1. M1 rises and M2 is unchanged
  2. Both fall by $1,000
  3. M1 falls and M2 is unchanged
  4. Both are unchanged
Show the answer

Checkable deposits are in M1; small time deposits are in M2 but not M1.

  • M1 rises and M2 is unchanged: Checkable deposits fell, so M1 falls, not rises.
  • Both fall by $1,000: The $1,000 stays in M2 as a small time deposit, so M2 does not fall.
  • Correct: M1 falls and M2 is unchanged: Right: the money leaves M1 but stays inside M2.
  • Both are unchanged: Checkable deposits are in M1 and time deposits are not, so M1 falls.

Data

What the people of Tolvia hold

Assets held by the public in the invented country of Tolvia, in billions of dollars (invented data for practice).
AssetBillions of dollars
Currency held by the public300
Checkable deposits500
Small time deposits (certificates of deposit)200
Retail money market funds150
Shares of stock2,000
Unused credit card limits400

5. Using the table, what is M1 in Tolvia, in billions of dollars?

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

M1 is the most spendable money: currency held by the public plus checkable deposits, 300+500=800300 + 500 = 800 billion.

  • Answer: 800

6. Using the table, what is M2 in Tolvia, in billions of dollars?

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

M2 is M1 plus small time deposits and retail money market funds: 800+200+150=1150800 + 200 + 150 = 1150 billion.

  • Answer: 1150

7. Which asset in the table is counted in M2 but not in M1?

  1. Currency held by the public
  2. Checkable deposits
  3. Small time deposits
  4. Shares of stock
Show the answer

M2 = M1 plus less liquid deposits: small time deposits and retail money market funds.

  • Currency held by the public: Currency is the core of M1, and M2 includes all of M1.
  • Checkable deposits: Checkable deposits can be spent by card or check, so they are in M1 (and so in M2).
  • Correct: Small time deposits: Right: certificates of deposit lock money up for a term, so they are near-money in M2 only.
  • Shares of stock: Stock is counted in neither; it is a financial asset, not money.

Part 9 · Summary

Summary

Money is whatever people accept as a medium of exchange, use as a unit of account and hold as a store of value. Modern money is fiat money, valued because the government declares it money and people accept it. M1 counts the most spendable money: currency held by the public and checkable deposits. M2 adds less liquid near-money, such as small time deposits and retail money market funds. Credit cards, stocks and bonds are not money.

Part 10 · Up next

What comes next

Part 11 · Connections

Connections

Question set for this topic