AP, IB, and College Microeconomic and Macroeconomic Principles 

6 Things to Know About Money by Test Day

All about Money

Updated 5/7/2018 Jacob Reed
1. What are the functions of money?

Medium of exchange: First and foremost, money serves as a medium of exchange. That means it is used to exchange goods and services as well as resources. Without money, resources would be exchanged for products through a barter system which would be inefficient, slow, and would have high transaction costs. Barter occurs when people trade stuff for stuff (like an umbrella for a book), but in order to have such trades, there must be a coincidence of wants. That is, person A must have what person B wants and B must have what person A wants.  

Rolled Bills

Unit of account: The second function of money is it serves as a unit of account. That means money can be used as a measuring tool (like a yard stick). If a friend tells you they bought a car for $2000, you have a picture in your mind of what a $2000 car looks like. The dollars serve to measure value so you have some sense as to how nice (or not nice in this case) the car must be. If, on the other hand, a friend tells you they bought a car for $50,000, you have a very different picture in your mind because $50,000 is a dramatically different measurement of value than $2000.

Store of Value: The third and final function of money is that it serves to store value. Resources, goods, and services can be cashed out at any time and their value can be stored in the form of money. If, for example, a farmer produces 1 ton of strawberries, the fruits of her labor will be worth nothing in just a few short weeks. The value of the strawberries can be stored by selling them for money. The money can store the value of the strawberries for the foreseeable future so it can be used by the farmer at some point in the future.

2. What gives money its value?

Commodity Money: The first forms of money were commodity money. That means the money itself had value. Wheat, cowrie shells, livestock or gold have all been forms of commodity money. Historically, precious metals have been the most common form of commodity money. The gold may be stamped in to a coin, but the gold will give the coin value even if there is no government or bank backing the coin. 

Representative Money: This is money that has some sort of commodity backing it up, or giving it value. Gold certificates used to be issued by banks. These paper notes could be exchanged for goods and services and at any point, a person could return to the bank and exchange the notes for the gold giving them value.

Fiat Money: Money today is fiat money. It represents value but it is not valuable in and of itself (paper is worth only a tiny fraction of the value printed on the bill). There is no gold, silver, cowrie shells, etc. giving US dollars value today. Fiat money has value because of legal decree (US bills are “legal tender for all debts public and private”) and because it can be exchanged for goods and services.

3. What are the measurements of the money supply?

The M1 money supply includes currency (coins and bills) and checkable deposits (also called demand deposits).  (See current M1 money supply)
M2: The M2 money supply includes all of M1 plus savings accounts, small time deposits (less than $100,000), and money market mutual funds. (See current M2 money supply)

4. How does the money supply impact price levels and output?

The Federal Reserve influences the money supply through monetary policy. The Fed’s actions shift the supply curve in the money marketwhich changes the real interest rate. The new interest rate changes investment and interest rate sensitive consumer spending which causes the AD curve to shift in the AS/AD model. Increases in the money supply generally cause an increase in price levels and output. Decreases in the money supply generally cause a decrease in price levels and output. 

5. What is the monetary equation of exchange (quantity theory of money)?

The Equation: M x V = P x Q = Nominal GDP
The variables in the monetary equation of exchange are:
M = Money Supply
V = Velocity of money (how many times a dollar is spent in a year)
P = Price level
Q = Real output (rGDP)
(Both M x V and P x Q equal nominal GDP.) 

6. What are the implications of the monetary equation of exchange?

If the velocity of money is stable (V), the money supply must increase when there are increases in real GDP (Q) if prices are to remain stable (P).  Also, increases in the money supply (while the velocity is stable) without concurrent increases in output will cause inflation (P rises). While the velocity of money is not stable (see the Federal Reserve’s M1 Velocity), the equation still holds true.

Up Next: 
Content Review Page: Time Value of Money

Other recommended resourcesACDC (functions of money), Khan Academy (money supply measuring), Marginal Revolution University(Quantity Theory of Money)