AP Macroeconomics · Unit 4 · Topic 4.3

The Money Study Lab

Money is any asset people widely accept as payment. The Federal Reserve measures it two ways: M1 holds the most liquid assets, and M2 adds near money such as small CDs and retail money market funds. Sort assets into M1, M2, or not money, count a household's money as it makes transactions, and drill the three functions of money.

1. Sort it, count it, use it

This lab uses the Federal Reserve's current definitions. Since 2020, M1 includes savings deposits. M2 is M1 plus small time deposits and retail money market funds.

A. What counts as money?

Pick where each item belongs. "M2 only" means it is in M2 but not in M1. Everything in M1 is also in M2. Correct answers drop into the diagram.

Where it lands M1 sits inside M2

B. Count a household's money

Edit what the Rivera household holds, or make a transaction. The chart and the tiles tally M1 and M2 as you go.

The Rivera household dollars by measure

CurrencyCheckingSavingsSmall CDsRetail MMMFStocks

Holdings

Currency in wallet Bills and coins

Checking deposits Spend by debit card or check

Savings deposits Includes money market deposit accounts

Small CDs Time deposits under $100,000

Retail money market funds Mutual fund shares

Stocks Must be sold before spending

Credit card limit Borrowing power, not an asset

Make a transaction

In M2 only (near money)

Last change

C. Functions and forms of money

Commodity money vs. fiat money

Commodity moneyHas value of its own as a good, apart from its use as money. Gold and silver coins, salt, cigarettes in a prison camp.

Fiat moneyHas value because the government declares it legal tender and people accept it. U.S. dollars, euros. Not backed by gold.

2. Key ideas

Definition

Money

Money is any asset that people widely accept as payment for goods and services. Its key feature is liquidity: how quickly and cheaply you can use it to buy something without losing value.

Three jobs

Functions of money

Medium of exchange: used to buy things, so no barter. Unit of account: prices are stated in it. Store of value: holds purchasing power over time. Inflation weakens the store of value.

Narrow measure

M1

Currency held by the public, plus checkable (demand) deposits, plus savings deposits. These are the most liquid assets. Since 2020 the Fed has counted savings deposits in M1.

Broad measure

M2

M2 = M1 + small time deposits (CDs under $100,000) + retail money market mutual funds. The extra pieces are near money: easy to turn into M1, but not spendable directly.

Not money

Credit cards, stocks, vault cash

A credit card creates a loan, which you repay with money. Stocks and bonds must be sold first. Currency inside banks is reserves, so it is left out of M1 to avoid counting it twice.

Forms

Commodity vs. fiat

Commodity money has value as a good, like gold coins. Fiat money has value because the government declares it legal tender and people trust it. U.S. currency is fiat money.

3. Money measures cheat sheet

The first table says where each asset counts. The second shows what common transactions do to M1 and M2 right away, before any bank lending (that comes in topic 4.4).

Asset	In M1?	In M2?	Why
Currency held by the public	Yes	Yes	Most liquid asset there is
Checkable (demand) deposits	Yes	Yes	Spent directly by check, debit card, or transfer
Savings deposits, money market deposit accounts	Yes	Yes	In M1 since the Fed's 2020 change
Small time deposits (CDs under $100,000)	No	Yes	Fixed term, early-withdrawal penalty
Retail money market mutual funds	No	Yes	Near money; sell shares to spend
Stocks, bonds, Treasury bills, large CDs	No	No	Financial assets, not money
Credit card limit or balance	No	No	A loan, not an asset you own
Currency in bank vaults	No	No	Bank reserves, not held by the public

Transaction	M1	M2
Deposit currency into checking	No change	No change
Move funds from checking to savings	No change	No change
Move funds from a small CD to checking	Increases	No change
Buy retail money market fund shares with checking	Decreases	No change
Charge a purchase on a credit card	No change	No change
Pay the credit card bill from checking	Decreases (for the household)	Decreases (for the household)

4. Writing it on the FRQ

How to earn the points

When asked how a transaction affects M1 or M2, give the direction first ("M1 decreases, M2 does not change"), then name the components: "checkable deposits fall and money market funds rise; both are in M2."
Show the sum when given numbers: M1 = currency + checkable deposits + savings deposits; M2 = M1 + small time deposits + retail money market funds.
For a cash deposit, answer "the money supply does not change immediately." Currency in circulation falls and demand deposits rise by the same amount. Any later growth comes from bank lending (topic 4.4).
Name the function precisely: "medium of exchange," "unit of account," or "store of value." Tie it to the example in one sentence.
If a question uses the older definition (savings deposits in M2 only), the prompt will usually list the components. Follow the components the question gives you.

Common mistakes

Calling a credit card money. It is a short-term loan; the money is the checking balance you later use to pay it off.
Calling a debit card money. The card is a tool; the checkable deposit behind it is the money.
Counting currency in bank vaults in M1. Only currency held by the public counts.
Mixing up a money market deposit account (a bank savings account, in M1) with a money market mutual fund (M2 only).
Using "money" to mean income or wealth. A person with a large stock portfolio is wealthy but may hold little money.
Saying inflation weakens the medium of exchange. The standard answer is that inflation weakens money as a store of value.

5. Practice questions

AP-style multiple choice. Pick an answer to see the explanation.

0 / 0 correct

6. Key terms

The vocabulary for topic 4.3. Read the list, flip through flashcards, or quiz yourself. For every term in the unit, see the Unit 4 terminology guide.