Functions of Money and M1 vs M2: AP Macro Guide

Money has three functions: it is a medium of exchange (you use it to buy things), a unit of account (prices are measured in it), and a store of value (it holds purchasing power over time). Economists then measure how much money exists with M1, the most liquid money such as currency and checking deposits, and M2, which is M1 plus less liquid "near money" such as small time deposits and retail money market funds. This guide covers each function, commodity versus fiat money, liquidity, and exactly what goes into M1 and M2, including a 2020 definition change that trips students up.

The three functions of money

Anything that performs all three of these jobs counts as money. The functions of money are tested as a set, so learn each one with an example.

1. Medium of exchange. Money is what you hand over to get a good or service. Without it, people would have to barter, trading goods directly. Barter requires a double coincidence of wants: a baker who wants shoes must find a shoemaker who happens to want bread at that moment. Money removes that problem, because the baker can sell bread to anyone for money and spend the money on shoes from anyone. The barter vs functions of money comparison lays the two systems side by side.

2. Unit of account. Money is the yardstick for measuring value. A store lists a jacket at $60 and a shirt at $20, so you can see at once that the jacket costs three shirts. In a barter economy with 100 goods, every good would need a price in terms of every other good, which works out to 4,950 separate exchange rates (100 × 99 / 2). With money, you need only 100 prices.

3. Store of value. Money lets you earn income today and spend it later. A $20 bill you keep in a drawer will still be accepted next year. Money is not the only store of value (houses, stocks, and bonds also hold value), but it is the one you can spend immediately. Inflation weakens this function: if prices rise 5% in a year, the $20 buys less than it did. That is why exam answers on the costs of inflation often say that inflation erodes money's store of value function.

A quick test for exam questions: if an item is widely accepted as payment, used to quote prices, and holds value over time, it is functioning as money. A credit card fails the store of value test and is not an asset at all. It is a way to take out a loan, which you later repay with money.

Commodity money vs fiat money

Money comes in two broad kinds.

Commodity money has value as a good in its own right, apart from its use as money. Gold coins, silver, salt, and cigarettes in prisoner of war camps are standard examples. If the item stopped being used as money, people would still want it for something else.

Fiat money has no value as a good. A paper dollar costs very little to print and has no use other than as money. It works because the government declares it legal tender and because people trust that others will accept it. The U.S. dollar, the euro, and the yen are all fiat money. In 1971 the United States stopped exchanging dollars for gold with foreign governments, which ended the dollar's practical link to gold.

The two types trade off in a predictable way. Commodity money holds value on its own, but its supply depends on mining and harvests rather than on the needs of the economy. Fiat money can be supplied in whatever quantity a central bank chooses, which allows monetary policy but also means its value depends on that central bank not creating too much of it. See fiat money vs commodity money for a full comparison.

Whatever form it takes, good money tends to share a few properties: it is durable, portable, divisible into small amounts, uniform (one dollar is the same as any other), limited in supply, and widely accepted.

Liquidity: the idea behind M1 and M2

Liquidity is how quickly and cheaply an asset can be turned into spending without losing value. Cash is perfectly liquid, since it is already spendable. A checking account balance is nearly as liquid, since you can pay with a debit card or a transfer. A savings account or a certificate of deposit (CD) takes a step or carries a penalty for early withdrawal. A house is highly illiquid: selling one takes weeks and costs thousands in fees.

The money supply measures are ranked by liquidity. M1 holds the most liquid assets. M2 starts with M1 and adds assets that are a little harder to spend right away.

What is in M1 and M2

Here is the definition most AP textbooks and review books use, which follows the way the Federal Reserve measured money before 2020:

• M1 = currency in circulation (bills and coins held by the public) + checkable deposits (checking accounts, also called demand deposits) + traveler's checks
• M2 = M1 + savings deposits (including money market deposit accounts) + small time deposits (CDs under $100,000) + retail money market mutual funds

Several things are left out of both measures:

• Currency in bank vaults. Cash a bank holds is part of its reserves, not money in the hands of the public. Counting it would double count the deposits it backs.
• Credit card limits. A credit line is borrowing capacity, not an asset anyone owns.
• Stocks and bonds. These are financial assets that must be sold before they can be spent.
• Large time deposits. CDs of $100,000 or more are left out of M2.

The 2020 definition change

The Federal Reserve changed its official definition in 2020. In April 2020 it removed a rule (part of Regulation D) that had limited savings accounts to six convenient transfers or withdrawals per month, such as online transfers, checks, and debit card payments. With that limit gone, savings deposits became nearly as easy to spend as checking deposits, so beginning with data for May 2020 the Fed counts savings deposits in M1. The official M1 series jumped by trillions of dollars at that point. The jump reflected the reclassification, not a sudden burst of money creation.

M2 was not affected, because savings deposits were already counted in it. They simply moved from the near money layer into the M1 layer.

Which definition should you use? Follow your course. If your teacher or textbook lists savings deposits under M2 only, use that on tests; if your course materials use the current Federal Reserve definition, put savings in M1. On any question, the safe statements are the same under both definitions: currency and checkable deposits are in M1, everything in M1 is also in M2, and M2 is always larger than M1. The M1 and M2 glossary entry and the M1 and M2 calculator walk through the classification.

Worked example: calculating M1 and M2

Suppose a hypothetical economy reports these figures, in billions of dollars:

Textbook definition (savings in M2 only).

M1 = $300 + $600 = $900 billion

M2 = $900 + $1,000 + $150 + $250 = $2,300 billion

Current Federal Reserve definition (savings in M1).

M1 = $300 + $600 + $1,000 = $1,900 billion

M2 = $1,900 + $150 + $250 = $2,300 billion

M2 comes out the same under both definitions, because the only change is which layer the savings deposits sit in. The vault cash ($50), large time deposits ($400), and credit card limits ($900) appear in neither measure.

Now test your understanding with two transactions, using the textbook definition:

• A household moves $20 billion from savings into checking. M1 rises from $900 to $920 billion. M2 stays at $2,300 billion, since both accounts were already in M2.
• A household withdraws $5 billion in cash from checking. Currency rises by $5 billion and checkable deposits fall by $5 billion, so M1 and M2 do not change. The money changed form, not amount.

That second transaction is a favorite exam question. Moving money between two items that sit inside the same measure never changes that measure.

Why the money supply matters for the rest of Unit 4

The measures above are the quantity the rest of the unit tries to explain and control. Banks expand checkable deposits when they lend out excess reserves, which is the process covered in how banks create money. The central bank's policy tools then change how much of that money exists, and the money market shows how the quantity of money and the demand for it set the nominal interest rate. The full topic summary is on the AP Macro topic 4.3 page.

How it shows up on the AP exam

Questions on this topic tend to take one of four shapes:

• Identify the function. A scenario describes money in use (a menu listing prices, a student saving birthday money, a cashier taking a $10 bill), and you name the function it shows: unit of account, store of value, or medium of exchange.
• Classify an item. You decide whether something is in M1, M2, both, or neither. Remember that every M1 item is also in M2.
• Calculate a measure. You add up the right components from a table, ignoring the distractors.
• Trace a transaction. You say whether moving funds between accounts changes M1, M2, or neither.

Common mistakes:

• Counting credit cards as money. They are a loan, not an asset.
• Counting vault cash in M1. Only currency held by the public counts.
• Double counting. Writing M2 as M1 plus a list that already includes currency and checking deposits.
• Mixing up unit of account and medium of exchange. Prices quoted in dollars show unit of account; paying with dollars shows medium of exchange.
• Saying a cash withdrawal reduces the money supply. It converts a deposit into currency, and both are in M1.