What is money, what does it do, and how is the money supply measured?
Topic 4.3 Definition, Measurement, and Functions of Money: state the functions of money, distinguish commodity and fiat money, and describe the money supply measures M1 and M2.
A focused answer to AP Macroeconomics Topic 4.3, covering the three functions of money, commodity versus fiat money, the characteristics of good money, and the money supply measures M1 and M2 with what each includes, with a worked question.
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What this topic is asking
Topic 4.3 defines money itself. The College Board wants you to state the three functions of money, distinguish commodity from fiat money, and know how the money supply is measured through M1 and M2. These definitions support the money market and monetary policy topics that follow.
The three functions of money
Anything that performs these functions can act as money; historically, the best money has been durable, portable, divisible, uniform, and limited in supply.
Commodity and fiat money
Measuring the money supply: M1 and M2
The money supply is measured in tiers, from most liquid to least.
Note that currency held in a bank's vault and the bank's reserves are not counted as part of the money supply in circulation, only money held by the public is. This matters when you trace banking and money creation in the next topic: when cash is deposited into a bank, the currency leaves circulation but the new checkable deposit is still part of M1, so the deposit itself does not change M1 directly. Money is created only when the bank lends out its excess reserves. Keeping the distinction between the tiers (M1 versus M2) and between money in circulation versus reserves clear is what lets you answer the common exam question of whether a given action raises, lowers, or leaves the money supply unchanged.
Try this
Q1. Name the three functions of money. [3 points]
- Cue. Medium of exchange, store of value, unit of account.
Q2. Is currency in circulation part of M1, M2, or both? [1 point]
- Cue. Both (M2 includes all of M1).
Exam-style practice questions
Practice questions written in the style of College Board exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
AP 2018 (style)1 marksMultiple choice. When you compare the price of two cars to decide which is cheaper, money is serving as a (A) medium of exchange. (B) store of value. (C) unit of account. (D) factor of production. (E) financial asset only.Show worked answer →
The answer is (C). Using money to express and compare prices is the unit-of-account function: money provides a common measure in which the value of all goods can be stated and compared.
(A) is using money to buy something. (B) is holding wealth over time. (D) and (E) are not functions of money. Comparing prices is the unit-of-account role, so (C).
AP 2021 (style)3 marksFree response. (a) State the three functions of money. (b) Explain the difference between commodity money and fiat money. (c) State whether a savings account is included in M1, M2, or both, and explain why.Show worked answer →
A 3-point definition FRQ.
(a) Functions (1 point): medium of exchange, store of value, and unit of account.
(b) Commodity versus fiat (1 point): commodity money has intrinsic value as a good (for example gold), whereas fiat money has no intrinsic value and is money only because the government declares it legal tender and people accept it.
(c) Savings account (1 point): it is included in M2 but not M1. M1 is the most liquid money (currency and checkable deposits); M2 adds less-liquid near-money such as savings accounts and small time deposits, so a savings account counts in M2.
Markers reward the three functions, the intrinsic-value contrast, and placing the savings account in M2.
Related dot points
- Topic 4.1 Financial Assets: define financial assets, distinguish stocks, bonds, and money, and explain the inverse relationship between bond prices and interest rates.
A focused answer to AP Macroeconomics Topic 4.1, covering financial assets, the differences between money, stocks, and bonds, the trade-off between liquidity, risk, and return, and the inverse relationship between bond prices and interest rates, with a worked question.
- Topic 4.4 Banking and the Expansion of the Money Supply: explain fractional-reserve banking, use a T-account balance sheet, and calculate the money multiplier and maximum change in the money supply.
A focused answer to AP Macroeconomics Topic 4.4, covering fractional-reserve banking, required and excess reserves, the T-account balance sheet, the money multiplier, and how to calculate the maximum change in the money supply from a new deposit, with full worked calculations.
- Topic 4.5 The Money Market: draw the money market, explain money demand and the vertical money supply, and show how shifts determine the equilibrium nominal interest rate.
A focused answer to AP Macroeconomics Topic 4.5, covering money demand and its determinants, the vertical money supply, money market equilibrium, and how changes in money supply or money demand change the nominal interest rate, with a worked graphing question.
- Topic 4.6 Monetary Policy: identify the central bank's tools, explain expansionary and contractionary monetary policy, and trace the transmission from the money market to aggregate demand.
A focused answer to AP Macroeconomics Topic 4.6, covering the central bank's tools (open-market operations, the reserve requirement, and the discount rate), expansionary and contractionary policy, and the full transmission chain from the money market to aggregate demand, with a worked graphing question.
- Topic 2.4 Price Indices and Inflation: define inflation and deflation, build and use the Consumer Price Index, calculate the inflation rate, and distinguish demand-pull from cost-push inflation.
A focused answer to AP Macroeconomics Topic 2.4, covering inflation and deflation, the Consumer Price Index and the market basket, calculating the CPI and the inflation rate, demand-pull versus cost-push inflation, and biases in the CPI, with full worked calculations.
Sources & how we know this
- AP Macroeconomics Course and Exam Description — College Board (2023)