Source: Principles of Macroeconomics textbook, Ch. 13
Tags: money, medium of exchange, store of value, unit of account, money supply, M1, M2, purchasing power, credit cards vs money, macroeconomics
Difficulty: Introductory
Prerequisites: Basic understanding of supply and demand (Chapter 3 or equivalent).
This is the chapter where the course shifts from real output and employment to the monetary side of the economy. Everything here lays the groundwork for understanding how central banks influence interest rates, inflation, and economic activity in later chapters. You need a firm grasp of what money is, how it is measured, and why its supply matters before any of the Federal Reserve material will make sense. If you skipped the earlier chapters on markets and prices, go back and review supply and demand first.
Money is anything widely accepted as payment for goods and services. Economists measure the money supply in two main ways (M1 and M2), each capturing different levels of liquidity. The value of money depends on its scarcity relative to goods and services: print too much and each unit buys less.
Medium of exchange
An asset used to buy and sell goods and services. In simple terms, it is the thing everyone in the economy agrees to accept as payment so that people do not have to barter directly.
Store of value
An asset that allows people to transfer purchasing power from one period to another. Think of it as the ability to earn money today and spend it next month without it becoming worthless.
Unit of account
A unit of measurement used by people to post prices and keep track of revenues and costs. In simple terms, it is the common yardstick that lets you compare the price of a sandwich to the price of a car.
M1 (narrow money)
The most liquid measure of the money supply. It includes currency in circulation, checking deposits (demand deposits and interest-earning checking deposits), and traveller's checks. Think of M1 as the money you can spend right now without converting anything first.
M2 (broad money)
A broader measure of money that includes everything in M1 plus savings deposits, time deposits, and money market mutual funds. These components are slightly less liquid, meaning you might need to transfer or wait a short period before spending them.
Purchasing power
The quantity of goods and services a unit of money can buy. When prices rise, the purchasing power of each pound or dollar falls.
Medium of exchange: Eliminates the need for a "double coincidence of wants" that barter requires. Without money, a baker who wants shoes must find a shoemaker who wants bread.
Store of value: Lets people save today's earnings for future use. Money is not the only store of value (property and shares work too), but it is the most liquid one.
Unit of account: Gives the economy a common measuring stick for prices. Every good is quoted in the same unit, making comparison straightforward.
Money's value comes from the same source as any commodity's value: demand relative to supply.
People demand money because it reduces the cost of exchange (compared with barter).
For purchasing power to remain stable, the supply of money must be limited.
When the supply of money grows rapidly relative to the supply of goods and services, each unit of money buys less. This is the basic mechanism behind inflation.
M1 components:
Currency (notes and coins in circulation)
Checking deposits (demand deposits and interest-earning checking deposits)
Traveller's checks
M2 components (everything in M1, plus):
Savings deposits
Time deposits (e.g. certificates of deposit)
Money market mutual funds
M2 is the broader measure. Items in M2 but not in M1 are considered "near money," meaning they can be converted to spendable cash relatively quickly but are not immediately spendable.
Money is an asset. A credit card balance is a liability.
Using a credit card is arranging a short-term loan, not spending money you already have.
Credit card purchases are therefore not included in the money supply. The payment you eventually make from your bank account to clear the credit card bill is the actual money transaction.
Every time a central bank announces it is "increasing the money supply," the mechanism at work is the supply-and-demand relationship described here. If a government prints currency to cover its debts (as happened in Zimbabwe in the late 2000s or Venezuela in the mid-2010s), the rapid growth of money relative to goods causes the purchasing power of each unit to collapse.
"Credit cards are money." They are not. Credit cards create a temporary loan. The money supply is measured by actual liquid assets, not lines of credit.
"M1 and M2 are completely separate pools of money." M2 includes M1 within it. M2 is the larger circle; M1 sits inside it.
"If the government prints more money, everyone gets richer." Printing money increases the supply but does not increase the supply of goods and services. The result is higher prices, not higher real wealth.
⚠️ Know the three functions of money and be able to identify which function a scenario describes (medium of exchange, store of value, or unit of account).
⚠️ Be able to list the components of M1 and M2 from memory. Exam questions frequently ask you to classify specific assets.
⚠️ Understand why credit cards are not money. This is a favourite multiple-choice trap.
⚠️ The relationship between money supply growth and purchasing power is foundational for later chapters on inflation.
True or False: A savings deposit is part of M1.
Fill in the blank: Money serves as a ________ of exchange, a store of ________, and a unit of ________.
True or False: If the money supply doubles while the quantity of goods stays the same, each unit of money can buy more.
True or False: A credit card balance is an asset.
Fill in the blank: M2 includes all of M1 plus ________, time deposits, and money market mutual funds.
(Answers: 1. False, it is in M2 but not M1. 2. medium, value, account. 3. False, purchasing power falls. 4. False, it is a liability. 5. savings deposits.)
Q: What are the three functions of money? Briefly explain each.
A: (1) Medium of exchange: used to buy and sell goods and services. (2) Store of value: allows people to transfer purchasing power from one time period to another. (3) Unit of account: a common measure for posting prices and tracking costs and revenues.
Q: List the components of M1 and explain how M2 differs from M1.
A: M1 includes currency, checking deposits (demand deposits and interest-earning checking deposits), and traveller's checks. M2 includes everything in M1 plus savings deposits, time deposits, and money market mutual funds. M2 is a broader, less liquid measure.
Q: Why are credit card purchases not considered part of the money supply?
A: A credit card purchase creates a loan (a liability), not a transfer of an existing asset. Money is an asset; credit card balances are debts. Only the payment made from a bank account to settle the credit card bill counts as a money transaction.
Q: What happens to the purchasing power of money if the money supply grows faster than the output of goods and services?
A: Purchasing power falls. Each unit of currency buys fewer goods and services, which is the basic mechanism of inflation.
This material connects directly to Chapter 14 and beyond, where the Federal Reserve's tools for changing the money supply are linked to interest rates, aggregate demand, and inflation. The supply-and-demand framework for money also ties back to the basic market model from early in the course. Understanding M1 and M2 is essential for interpreting real-world Fed announcements and monetary policy debates.
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