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4.3 Definition, Measurement, and Functions of Money

4 min readjanuary 3, 2023

J

Jeanne Stansak

Haseung Jun

Haseung Jun

J

Jeanne Stansak

Haseung Jun

Haseung Jun

Money can take several forms. One form is what we call . is something that serves as money or currency and has no other important uses. Examples of include our paper money and coins. Another form of money is called commodity money. Commodity money is something that performs the function of money and has an alternative, non-monetary use. Some examples are gold, silver, oil, precious metals, and tobacco.

Functions of Money

There are three functions of money: medium of exchange, , and .

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-Us4mprFaqq1h.png?alt=media&token=e48b361b-0355-4b18-afd7-bd9f7bd123cb

In order for something to be considered money, it has to satisfy these three functions. There are various examples of each of the functions.

Medium of Exchange

Money must always be able to be easily transacted. If you want to buy apples, you should be able to at the local grocery store without much problem. In a sense, it's a convenient way to exchange what you have for what the grocery store has. Think of getting paid. It's also an efficient way to get rewarded for your work without creating a hassle about what you should get.

Look at the image below. How do you know if your goat is worth the same as a lamb? Should you get a lamb in return for your goat? Is it a fair trade? What if goats are more valuable? How do you know what to add to the trade in order to make it a fair one? With money, everything's laid out, no problems in buying or selling, whether it's a good or labor.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2Fwhatsapp_image_2022-04-13_at_11.57-1UCKhToNYSR7.jpeg?alt=media&token=2e14cc92-ecbf-4feb-96fb-9fa60d25bd97

Image Courtesy of Study.com

Unit of Account

It also has to be able to show value. How do you know if cheese is more valuable than eggs? How do you know if diamonds are more valuable than a pencil? Usually, we look at the price. If the price of a diamond is higher than a pencil, you know it's more valuable.

Or think about a house? How do you know if your house is more valuable than the house across the street? Money (or price) sets a value that everyone can understand. It's almost a universal measurement system of value.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2Fgolden-media.s3.amazonaws-cxCvqpdiU2sL.jpeg?alt=media&token=3c474db3-b3cf-4434-9b4c-43c27e7a59d1

Image Courtesy of Golden

Store of Value

Lastly, we have a . This means you can store its value without losing it (this of course, only stands true if prices are not increasing too rapidly). If you hide your $20 allowance under your bed, chances are, it'll still hold its value the next week or even the next year. If you hide your favorite Oreos under your bed, after a month, it won't hold its original value of being an awesome delicious cookie. Instead, it'll just be a piece of baked flour with moldy cream in between.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2FScreen-Shot-2019-01-11-at-4.27-S7kfjLVXVFW9.png?alt=media&token=9fca5d97-c95f-452d-a869-c63520c3ae16

Image Courtesy of Techonomy

Examples:

  • A high school senior depositing his part-time salary into a savings account is an example of the function . Another example of is a bank investing $10 million into a portfolio of stocks and bonds.

  • An example of the function is when a name-brand good is twice as expensive as a similar, generic good.

  • A retired couple spending $9000 on a month-long European vacation is an example of the function: medium of exchange.

Measurements of the Money Supply

Different types of money are placed into categories based on what they include, their , and what function they typically perform. refers to how easily something can be converted to cash. Surprisingly, one thing that is not considered money is a credit card. A credit card is actually a short-term loan with excessive interest rates. The is measured by adding M1 and M2. These are two categories of money that matter for the AP exam, although a new category of M3 has been recently emerging.

  • M1 = cash + coins + checking deposits + traveler's checks

  • M2 = M1 + savings deposits + small time deposits + money market deposits + money market mutual funds

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-hYjHtisCeEng.png?alt=media&token=a495f9f3-46c2-4f16-9e97-b423595aab26

M1 and M2 together refer to the . Because even money has its own market, we keep track of the supply of money. In this case, the supply of money is constant (think about it!) so we have a vertical supply curve.

Monetary Base

The monetary base (M0 or MB) refers to the money in circulation or in the bank reserves. It's basically the physical paper and coin currency that is being used by the economy and bank deposits. This is NOT included in the . Instead, it details the final settlement of transaction. If you use cash to pay off debt, that's monetary base. But if you use a credit card to do so, it's not because credit cards are not the final step of the transaction.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-RmoqOHLF5Yew.png?alt=media&token=417c403d-dcbf-4a59-95eb-62dc5acbf87a

Image Courtesy of CFI

Key Terms to Review (6)

Fiat Money

: Fiat money refers to currency that is not backed by a physical commodity, such as gold or silver. Its value is derived from the trust and confidence people have in the government that issues it.

Liquidity

: Liquidity refers to how easily an asset can be converted into cash without significant loss in its value.

Monetary Base (M0 or MB)

: The monetary base, also known as M0 or MB, refers to the total amount of money in an economy that is held by the central bank. It includes physical currency (coins and notes) in circulation and reserves held by commercial banks.

Money Supply

: Money supply refers to all physical currency (coins and paper bills) circulating in an economy along with demand deposits held by individuals and businesses in commercial banks.

Store of Value

: A store of value is an attribute of money that enables it to hold its purchasing power over time.

Unit of Account

: A unit of account is a function of money that allows it to be used as a common measure for expressing the value of goods, services, and assets.

4.3 Definition, Measurement, and Functions of Money

4 min readjanuary 3, 2023

J

Jeanne Stansak

Haseung Jun

Haseung Jun

J

Jeanne Stansak

Haseung Jun

Haseung Jun

Money can take several forms. One form is what we call . is something that serves as money or currency and has no other important uses. Examples of include our paper money and coins. Another form of money is called commodity money. Commodity money is something that performs the function of money and has an alternative, non-monetary use. Some examples are gold, silver, oil, precious metals, and tobacco.

Functions of Money

There are three functions of money: medium of exchange, , and .

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-Us4mprFaqq1h.png?alt=media&token=e48b361b-0355-4b18-afd7-bd9f7bd123cb

In order for something to be considered money, it has to satisfy these three functions. There are various examples of each of the functions.

Medium of Exchange

Money must always be able to be easily transacted. If you want to buy apples, you should be able to at the local grocery store without much problem. In a sense, it's a convenient way to exchange what you have for what the grocery store has. Think of getting paid. It's also an efficient way to get rewarded for your work without creating a hassle about what you should get.

Look at the image below. How do you know if your goat is worth the same as a lamb? Should you get a lamb in return for your goat? Is it a fair trade? What if goats are more valuable? How do you know what to add to the trade in order to make it a fair one? With money, everything's laid out, no problems in buying or selling, whether it's a good or labor.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2Fwhatsapp_image_2022-04-13_at_11.57-1UCKhToNYSR7.jpeg?alt=media&token=2e14cc92-ecbf-4feb-96fb-9fa60d25bd97

Image Courtesy of Study.com

Unit of Account

It also has to be able to show value. How do you know if cheese is more valuable than eggs? How do you know if diamonds are more valuable than a pencil? Usually, we look at the price. If the price of a diamond is higher than a pencil, you know it's more valuable.

Or think about a house? How do you know if your house is more valuable than the house across the street? Money (or price) sets a value that everyone can understand. It's almost a universal measurement system of value.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2Fgolden-media.s3.amazonaws-cxCvqpdiU2sL.jpeg?alt=media&token=3c474db3-b3cf-4434-9b4c-43c27e7a59d1

Image Courtesy of Golden

Store of Value

Lastly, we have a . This means you can store its value without losing it (this of course, only stands true if prices are not increasing too rapidly). If you hide your $20 allowance under your bed, chances are, it'll still hold its value the next week or even the next year. If you hide your favorite Oreos under your bed, after a month, it won't hold its original value of being an awesome delicious cookie. Instead, it'll just be a piece of baked flour with moldy cream in between.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2FScreen-Shot-2019-01-11-at-4.27-S7kfjLVXVFW9.png?alt=media&token=9fca5d97-c95f-452d-a869-c63520c3ae16

Image Courtesy of Techonomy

Examples:

  • A high school senior depositing his part-time salary into a savings account is an example of the function . Another example of is a bank investing $10 million into a portfolio of stocks and bonds.

  • An example of the function is when a name-brand good is twice as expensive as a similar, generic good.

  • A retired couple spending $9000 on a month-long European vacation is an example of the function: medium of exchange.

Measurements of the Money Supply

Different types of money are placed into categories based on what they include, their , and what function they typically perform. refers to how easily something can be converted to cash. Surprisingly, one thing that is not considered money is a credit card. A credit card is actually a short-term loan with excessive interest rates. The is measured by adding M1 and M2. These are two categories of money that matter for the AP exam, although a new category of M3 has been recently emerging.

  • M1 = cash + coins + checking deposits + traveler's checks

  • M2 = M1 + savings deposits + small time deposits + money market deposits + money market mutual funds

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-hYjHtisCeEng.png?alt=media&token=a495f9f3-46c2-4f16-9e97-b423595aab26

M1 and M2 together refer to the . Because even money has its own market, we keep track of the supply of money. In this case, the supply of money is constant (think about it!) so we have a vertical supply curve.

Monetary Base

The monetary base (M0 or MB) refers to the money in circulation or in the bank reserves. It's basically the physical paper and coin currency that is being used by the economy and bank deposits. This is NOT included in the . Instead, it details the final settlement of transaction. If you use cash to pay off debt, that's monetary base. But if you use a credit card to do so, it's not because credit cards are not the final step of the transaction.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-RmoqOHLF5Yew.png?alt=media&token=417c403d-dcbf-4a59-95eb-62dc5acbf87a

Image Courtesy of CFI

Key Terms to Review (6)

Fiat Money

: Fiat money refers to currency that is not backed by a physical commodity, such as gold or silver. Its value is derived from the trust and confidence people have in the government that issues it.

Liquidity

: Liquidity refers to how easily an asset can be converted into cash without significant loss in its value.

Monetary Base (M0 or MB)

: The monetary base, also known as M0 or MB, refers to the total amount of money in an economy that is held by the central bank. It includes physical currency (coins and notes) in circulation and reserves held by commercial banks.

Money Supply

: Money supply refers to all physical currency (coins and paper bills) circulating in an economy along with demand deposits held by individuals and businesses in commercial banks.

Store of Value

: A store of value is an attribute of money that enables it to hold its purchasing power over time.

Unit of Account

: A unit of account is a function of money that allows it to be used as a common measure for expressing the value of goods, services, and assets.


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© 2024 Fiveable Inc. All rights reserved.

AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.