A restaurant lists a sandwich at $12 and a salad at $9 so customers can compare their prices on one scale. Which function of money does this illustrate?
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Economics · Foundations
Money
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Money Anything a community regularly accepts as payment for goods and services; defined by its functions, not by its physical material. Full entry → is anything people routinely accept to buy and sell. It does three jobs: it serves as a Medium of exchange The role money plays as the intermediary in trades, so goods and services are exchanged for money rather than for other goods. Full entry →, a Unit of account The common measure in which prices, debts, and wealth are stated, allowing values to be compared on one scale. Full entry →, and a Store of value The ability of money to hold purchasing power over time so it can be saved and spent later. Full entry →. By being universally accepted, money removes barter's "Double coincidence of wants The barter requirement that each trader must want exactly what the other offers before a trade can occur. Full entry →." Modern dollars are Fiat money Money with no intrinsic value that is accepted because a government declares it legal tender and people trust others will take it. Full entry → — they have no commodity backing and are valuable because the government makes them Legal tender Money that must be accepted to settle a debt; U.S. currency states that it is legal tender for all debts, public and private. Full entry → and everyone trusts they will be accepted. Economists track how much money exists using the measures M1 and M2.
Why this matters
Almost every economic transaction you make runs through money, yet most people never ask what makes a dollar "money" rather than a colorful piece of paper. Understanding money's three functions clarifies why economies with unstable money struggle: when prices swing wildly, money stops working as a unit of account and a store of value, and people fall back toward barter or a foreign currency. Knowing what M1 and M2 measure also lets you read the news about the money supply, banking, and the Federal Reserve with a clear idea of what is actually being counted — and what is not.
The college version
From barter to money
A barter economy trades goods directly for other goods. For any trade to happen, each side must want exactly what the other offers — economists call this the double coincidence of wants. An accountant who needs shoes has to find a shoemaker who happens to need accounting help, in the right size, at the right time. As the number of goods grows, the number of possible good-for-good prices explodes and most potential trades never occur. Money removes the problem. Because sellers accept money from anyone, the accountant sells services for money and spends that money on shoes from a shoemaker who need never want accounting at all. This is why money is defined not by what it is made of but by what it does: money is whatever a community regularly accepts in exchange for goods and services.
The three functions of money
Economists identify money by three jobs it performs. First, as a medium of exchange, money is the intermediary that stands between buyer and seller, so goods trade for money rather than for other goods. Second, as a unit of account, money is the common ruler in which prices, debts, and wealth are quoted; listing a sandwich at $12 and a salad at $9 lets buyers compare value on a single scale instead of memorizing thousands of good-for-good ratios. Third, as a store of value, money holds purchasing power over time, so income earned today can be spent next week or next year. Money is not the only store of value — houses, stocks, and gold store value too — but it is the most liquid, meaning it can be spent immediately without first being converted into something else. (Some textbooks add a fourth function, a standard of deferred payment, for money's role in loans and contracts settled in the future.) The store-of-value function is the one inflation attacks: when the general price level rises, each dollar buys less, so persistent inflation erodes money's ability to store value — a mechanism the inflation topic develops in full.
Commodity, commodity-backed, and fiat money
Money has taken three broad forms. Commodity money Money that is a good with intrinsic value of its own, such as gold, silver, or salt, which also circulates as a means of payment. Full entry → is a good that has value in its own right and also circulates as money — gold and silver coins, but historically also cowrie shells, salt, and cigarettes in prison economies. Commodity-backed money is paper currency that a bank or government promises to redeem for a fixed amount of a commodity, such as gold-backed dollars; the paper is convenient to carry, and the commodity stands behind it. Fiat money has no intrinsic value and is not redeemable for any commodity; it is money because a government declares it legal tender and because people trust that others will accept it. Modern U.S. dollars are fiat money — a Federal Reserve note is worth a dollar because it is accepted, not because it can be exchanged for metal. Every bill carries the statement that it is legal tender for all debts, public and private, meaning creditors must accept it to settle debts.
Measuring the money supply: M1 and M2
Because "money" includes more than the cash in circulation, the Federal Reserve reports two main measures of the money supply, from narrowest to broadest. M1 counts the most liquid forms: currency held by the public (outside banks, the U.S. Treasury, and the Fed), demand deposits such as checking accounts, and other liquid deposits. Since May 2020 that last category includes savings deposits: after the Fed removed the six-transfers-per-month limit on savings accounts in Regulation D, savings deposits gained the same liquidity as checking accounts and were reclassified into M1, a change that raised measured M1 by roughly $11 trillion. M2 is broader: it equals M1 plus small-denomination time deposits (certificates of deposit under $100,000) and balances in retail money-market funds. These additions are "near money" — easy to convert to cash but not directly spendable at the register. Every dollar in M1 is also in M2, so M2 is always the larger figure. Note what these measures leave out and hand off: how banks create deposit money through lending belongs to the banking topic, and how the Federal Reserve and its policy tools change the money supply belong to the federal-reserve and monetary-policy topics.
Eli explains
The same idea, in plain words
Explain it like I’m 10
Imagine you fix bikes and you want a pizza, but the pizza maker doesn't want a bike fixed. Without money you're stuck hunting for someone who wants exactly what you have and has exactly what you want. Money fixes that: everyone agrees to accept it, so you fix a bike for money and hand that money to the pizza maker. Money does three things at once. It's the thing you trade with (medium of exchange), the way you put a price on things so you can compare them (unit of account), and a way to save up for later because it keeps its value for a while (store of value). Today's dollars aren't backed by gold — they're 'fiat' money, worth a dollar simply because the government says so and because everyone else takes them too.
Picture it like this
Money is like a language everyone in a country has agreed to speak. A plumber and a baker who share no skills can still 'talk' to each other through money: the plumber earns money from anyone and spends it with the baker, the same way two strangers who both know English can understand each other even though they've never met.
Where the picture stops working
The analogy breaks down on scarcity. Teaching more people a language only helps communication, but printing much more money doesn't make everyone richer — it just makes each unit buy less, which is inflation. Money's value depends on it staying relatively scarce and stable, while a language loses nothing when more people use it.
Worked example
Suppose you hold four things: $200 in cash in your wallet, $1,500 in a checking account, $6,000 in a savings account, and a $5,000 certificate of deposit (a time deposit under $100,000). Which money-supply measures count each one? The cash, the checking balance, and — since the May 2020 reclassification — the savings account are all "other liquid" or demand deposits, so all three are in M1 (and therefore also in M2). The $5,000 CD is a small-denomination time deposit: it is not liquid enough for M1, so it is counted in M2 only. Your contribution to M1 is $200 + $1,500 + $6,000 = $7,700; your contribution to M2 is $7,700 + $5,000 = $12,700. The example shows that M2 always contains everything in M1 plus the near-money items.
Key takeaway
Money is defined by what it does — serving as a medium of exchange, a unit of account, and a store of value — not by what it is made of. Modern dollars are fiat money, and economists gauge the total supply with the nested measures M1 and M2.
Quick check
3 questions here, of 5 in this lesson’s practice set. Answers stay hidden until you check.
A plumber wants bread, but the only baker nearby wants electrical work, not plumbing. In a pure barter system this trade stalls. What is the underlying problem, and how does money resolve it?
Choose an answer, then check it.
What makes modern U.S. dollars an example of fiat money?
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Study tools & related lessonsYou’ll learn to · Common mistakes · Easily confused · Key vocabulary · Related
You’ll learn to
- Define money by the roles it plays rather than by its physical form.
- Explain the three functions of money and the problem each one solves.
- Describe the double coincidence of wants and how a universally accepted medium of exchange eliminates it.
- Distinguish commodity money, commodity-backed money, and fiat money, and classify modern U.S. currency.
- Compare the M1 and M2 money-supply measures and identify what each includes.
Common mistakes
Thinking money must be backed by gold or another commodity to have value.
Modern money is fiat: it is valuable because it is legal tender and widely accepted, not because it can be redeemed for a commodity.
Treating "money" as the same thing as wealth or income.
Money is a specific, liquid medium of exchange. Wealth includes many non-money assets such as houses and stocks, and income is a flow earned over time rather than a stock of money held.
Believing M1 and M2 are two separate pools of money.
The measures are nested: M2 contains all of M1 plus additional near-money, so M2 is always at least as large as M1.
Assuming physical cash is the only thing that counts as money.
Checkable and other liquid deposits make up most of M1; currency in circulation is only part of the money supply.
Counting a small certificate of deposit in M1.
Small-denomination time deposits sit in M2 but not M1, because they are less liquid than cash, checking, or savings balances.
Easily confused
Commodity money vs. Fiat money
Commodity money has intrinsic value as a good in its own right; fiat money has no intrinsic value and is money only by government declaration and public acceptance.
Medium of exchange vs. Store of value
The medium-of-exchange function is about completing trades now; the store-of-value function is about holding purchasing power to spend later.
M1 vs. M2
M1 is the narrower, most-liquid measure of the money supply; M2 adds small time deposits and retail money-market funds and always exceeds M1.
Key vocabulary
- Money
- Anything a community regularly accepts as payment for goods and services; defined by its functions, not by its physical material.
- Medium of exchange
- The role money plays as the intermediary in trades, so goods and services are exchanged for money rather than for other goods.
- Unit of account
- The common measure in which prices, debts, and wealth are stated, allowing values to be compared on one scale.
- Store of value
- The ability of money to hold purchasing power over time so it can be saved and spent later.
- Double coincidence of wants
- The barter requirement that each trader must want exactly what the other offers before a trade can occur.
- Commodity money
- Money that is a good with intrinsic value of its own, such as gold, silver, or salt, which also circulates as a means of payment.
- Fiat money
- Money with no intrinsic value that is accepted because a government declares it legal tender and people trust others will take it.
- Legal tender
- Money that must be accepted to settle a debt; U.S. currency states that it is legal tender for all debts, public and private.
- M1
- The narrowest common money-supply measure: currency held by the public, demand deposits, and other liquid deposits including savings accounts.
- M2
- A broader money-supply measure equal to M1 plus small-denomination time deposits and balances in retail money-market funds.
Sources & references
- Principles of Macroeconomics 3e, Section 14.1: Defining Money by Its Functions — OpenStax, Rice University (Steven A. Greenlaw, David Shapiro, Daniel MacDonald)
- Principles of Macroeconomics 3e, Section 14.2: Measuring Money: Currency, M1, and M2 — OpenStax, Rice University (Steven A. Greenlaw, David Shapiro, Daniel MacDonald)
- Money Stock Measures — H.6 Release (current), with definitions of M1 and M2 — Board of Governors of the Federal Reserve System
- Money Stock Measures — H.6 Release: Technical Q&As (May 2020 reclassification of savings deposits) — Board of Governors of the Federal Reserve System
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Researched 2026-08-19
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