Difficulty: Introductory to Intermediate | Prerequisites: Part 1 of this unit (financial assets, interest rates).
Before you can understand how the Fed controls the economy, you need to know what money actually is, how it is measured, and how banks create more of it through lending. Topics 4.3 and 4.4 cover the definition and functions of money, the difference between M1 and M2, and the mechanics of fractional reserve banking and the money multiplier. This is the machinery that sits behind every monetary policy tool you will study in Topics 4.5–4.6. If you are coming in cold, make sure you are comfortable with the idea of interest rates from Topics 4.1–4.2 first.
Money is anything generally accepted as payment. It comes in different forms (commodity and fiat) and serves three functions: medium of exchange, unit of account, and store of value. Banks do not keep all your deposits in a vault; they lend most of it out, and this process of fractional reserve banking is how the money supply expands beyond what the central bank originally created.
Barter system
A system where goods and services are traded directly for other goods and services, with no money involved. The main problem is the "double coincidence of wants," meaning both parties must want what the other has.
Money
Anything generally accepted as payment for goods and services. It is not the same as wealth or income.
Wealth
The total collection of assets a person or entity owns. Think of it as a snapshot of everything you have at one moment.
Income
A flow of earnings per unit of time (e.g. your monthly salary). Think of it as a stream, not a pool.
Commodity money
Money that has intrinsic value beyond its use as currency, such as gold or silver coins. The material itself is worth something.
Fiat money
Money that has no intrinsic value; it works only because the government declares it legal tender and people accept it. Paper notes and coins in modern economies are fiat money.
Three functions of money
Medium of exchange: you use it to buy things.
Unit of account: you use it to measure and compare the value of goods and services.
Store of value: you can hold onto it and it will retain purchasing power over time (at least roughly).
Purchasing power of money
The quantity of goods and services one unit of money can buy. Inflation reduces purchasing power; deflation increases it.
Liquidity (in the context of money measurement)
How easily and quickly an asset can be used as a medium of exchange. Cash is the most liquid. A certificate of deposit is less liquid because you face penalties for early withdrawal.
M1
The most liquid measure of money supply. Includes currency in circulation, checkable bank deposits (current accounts), and traveller's cheques.
M2
A broader measure that includes everything in M1 plus "near-moneys": savings deposits, time deposits (certificates of deposit), and money market funds. These are slightly less liquid than M1 components.
Fractional reserve banking
The system in which banks hold only a fraction of deposits as reserves and lend out the rest. This is how banks create money.
Demand deposits
Money deposited in a commercial bank in a current (checking) account. The depositor can withdraw it on demand.
Required reserves
The percentage of demand deposits that banks must hold by law and cannot lend out. Set by the central bank.
Excess reserves
The portion of deposits that a bank can lend out, over and above its required reserves. This is where money creation happens.
Money multiplier
The maximum amount by which a new deposit can expand the money supply through the banking system. Calculated as 1 / Reserve requirement (expressed as a decimal).
Balance sheet
A record of a bank's assets (what it owns), liabilities (what it owes), and net worth.
For something to function well as money, it needs to be:
Generally accepted by the public.
Scarce enough to hold value.
Portable and divisible so it can be used for transactions of any size.
Inflation decreases the purchasing power of money. Each unit buys fewer goods and services.
Hyperinflation destroys money's acceptability altogether. People start refusing the currency and may revert to barter or adopt a foreign currency.
M1 is the narrow, most liquid measure: cash, current account deposits, traveller's cheques.
M2 is M1 plus near-moneys: savings accounts, time deposits (CDs), money market funds.
For the AP exam, know which items belong in which category.
Banks receive deposits and are required to hold only a fraction (the reserve requirement) in reserve.
Everything above the reserve requirement is excess reserves, which banks lend out.
When a bank lends money, that loan becomes a new deposit at another bank, which then holds its required reserve and lends out the rest. This process repeats.
The total money created through this chain is captured by the money multiplier.
Formula: Money multiplier = 1 / Reserve requirement
Example: if the reserve requirement is 10% (0.10), the multiplier is 1 / 0.10 = 10.
An initial deposit of $1,000 with a 10% reserve requirement could expand the money supply by up to $10,000 in total.
The multiplier gives the maximum potential expansion. In practice, if banks hold extra reserves or borrowers hold cash, the actual expansion is smaller.
Assets are things a bank owns: reserves and loans.
Liabilities are things a bank owes: deposits.
A new deposit increases both assets (reserves go up) and liabilities (the bank owes the depositor).
When the bank makes a loan, reserves decrease and loans (another asset) increase by the same amount.
Money multiplier:
Money multiplier = 1 / Reserve requirement (as a decimal)
Maximum change in the money supply from a new deposit:
Maximum change = Initial deposit × Money multiplier
Maximum money a single bank can lend from a new deposit:
Loan amount = Deposit × (1 – Reserve requirement)
Fractional reserve banking is the reason a "bank run" can be devastating: if every depositor shows up at once, the bank does not have enough cash because most of it has been lent out. This is exactly what happened during the Great Depression and, in a modern form, during the 2008 financial crisis with institutions like Northern Rock. Deposit insurance (FDIC in the US) exists specifically to prevent panic withdrawals.
Students frequently confuse money, wealth, and income. Money is a medium of exchange. Wealth is total assets. Income is a flow over time. A house is wealth, not money.
Students often think M2 is a separate category from M1. It is not. M2 includes everything in M1 plus additional, less liquid items.
A common mistake is applying the money multiplier to the total deposit rather than to the excess reserves when calculating how much a single bank can lend. A single bank can only lend its excess reserves; the multiplier effect comes from the entire banking system.
Students sometimes forget that the money multiplier gives a maximum. Real-world money creation is usually smaller.
⚠️ Know the three functions of money and be able to identify which function is being described in a scenario.
⚠️ M1 vs M2 classification questions appear regularly. Memorise which items fall where.
⚠️ The money multiplier formula (1 / Reserve requirement) and its application are heavily tested. Be ready to calculate the maximum change in the money supply from a given deposit or change in reserves.
⚠️ Balance sheet questions can appear on the free-response section. Practise filling in a T-account showing what happens when a deposit is made and a loan is issued.
True or False: Fiat money has intrinsic value.
Name the three functions of money.
The reserve requirement is 20%. The money multiplier is ______.
True or False: M2 includes all of M1.
A bank receives a $5,000 deposit with a 10% reserve requirement. The maximum amount this single bank can lend is $______.
Answers: 1. False (fiat money has no intrinsic value). 2. Medium of exchange, unit of account, store of value. 3. 5 (1/0.20). 4. True. 5. $4,500 ($5,000 × 0.90).
Q: What is the difference between commodity money and fiat money?
A: Commodity money has intrinsic value (e.g. gold coins are valuable as gold). Fiat money has no intrinsic value and is accepted only because the government declares it legal tender and the public trusts it.
Q: A bank has $100,000 in demand deposits and the reserve requirement is 10%. How much must the bank hold in required reserves, and how much can it lend?
A: Required reserves = $100,000 × 0.10 = $10,000. The bank can lend $90,000 (its excess reserves).
Q: If the reserve requirement is 25% and a new $2,000 deposit enters the banking system, what is the maximum total increase in the money supply?
A: Money multiplier = 1 / 0.25 = 4. Maximum increase = $2,000 × 4 = $8,000.
Q: Why is inflation harmful to money's function as a store of value?
A: Inflation erodes purchasing power over time. If prices rise, each unit of money buys fewer goods and services, so holding money means losing real value. During hyperinflation, money can fail as a store of value entirely.
Q: Explain how fractional reserve banking leads to money creation.
A: Banks lend out their excess reserves. Those loans are deposited in other banks, which then hold their required reserves and lend out the rest. Each round of lending creates new money (in the form of deposits) until the entire money multiplier effect is exhausted.
Fractional reserve banking connects directly to monetary policy (Topic 4.6), because the Fed's tools (reserve requirement, discount rate, open market operations) all work by changing how much banks can lend. The money supply itself feeds into the money market graph (Topic 4.5), where changes in money supply shift the vertical supply curve and alter the interest rate, which in turn shifts aggregate demand.
money, barter system, commodity money, fiat money, M1, M2, near-moneys, medium of exchange, unit of account, store of value, fractional reserve banking, money multiplier, reserve requirement, required reserves, excess reserves, demand deposits, balance sheet, T-account, bank reserves, money creation, AP Macro Unit 4, Topic 4.3, Topic 4.4, AP Macroeconomics review