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Lesson M05.L03: Money: Functions, Types, and Measures in Australia

Module: Fiscal Policy, Money, Prices, and the Reserve Bank Level: intro Duration: 30 minutes Learning Objective: List the three functions of money and distinguish M1, M3, and broad money aggregates using RBA data. Data as of: 2024 Provenance: RBA Education | RBA | OpenStax Macro 3e

Explanation

Money is anything widely accepted as payment for goods and services. Economists identify three core functions that money performs:

  1. Medium of exchange: Money eliminates the need for a double coincidence of wants (the problem with barter). You don't need to find someone who wants exactly what you have. Instead, you accept money from your buyer and use it to buy from anyone else.

  2. Unit of account: Money provides a common measuring stick for prices. Without it, you'd need to express every price relative to every other good. The Australian dollar (AUD) lets us compare the price of a haircut with the price of a car.

  3. Store of value: Money holds its value over time, allowing you to save purchasing power for the future. (Inflation erodes this function — one reason price stability matters.)

The Reserve Bank of Australia (RBA) measures the money supply using several aggregates:

  • M1 (narrow money): Currency in circulation (coins and notes) plus bank deposits that can be accessed on demand (current/transaction accounts). Most "spendable" money.
  • M3 (broad money): M1 plus all other deposits at banks and credit unions (term deposits, savings accounts). A wider view of liquidity.
  • Broad money: M3 plus borrowings from the private sector by authorised deposit-taking institutions (ADIs), minus holdings between those institutions. The most comprehensive measure.

As of 2024, Australia's broad money supply was approximately $3.4 trillion AUD. M1 was substantially smaller — roughly $1.5 trillion — reflecting the large stock of term deposits and savings accounts in M3.

Worked Example

Scenario: Identify which components belong to which monetary aggregate.

Suppose the RBA reports the following (simplified figures in $bn):

Component Value ($bn)
Currency in circulation (notes and coins) 100
Transaction/current account deposits 900
Term deposits at banks 800
Savings accounts at credit unions 300
Other ADI borrowings (net) 200

Step 1 – Calculate M1: M1 = Currency + Transaction deposits M1 = $100bn + \(900bn = **\)1,000bn**

Step 2 – Calculate M3: M3 = M1 + Term deposits + Savings at credit unions M3 = $1,000bn + $800bn + \(300bn = **\)2,100bn**

Step 3 – Calculate Broad Money: Broad Money = M3 + Other ADI borrowings (net) Broad Money = $2,100bn + \(200bn = **\)2,300bn**

Conclusion: Each aggregate is progressively broader. M1 measures money most immediately available for spending; Broad Money captures the full spectrum of liquid financial assets in the economy.

Common Misconception

Misconception: "Most of the money in the economy consists of physical cash (notes and coins)."

Correction: Physical currency is only a small fraction of the total money supply. The vast majority of money in modern Australia exists as electronic deposits in bank accounts. As of 2024, currency in circulation was roughly $100 billion, while M3 exceeded $3 trillion — meaning notes and coins represent only about 3% of the broad money supply. Most transactions are settled electronically.

Practice Prompts

  1. Name the three functions of money and give a brief example of each in an Australian context. → Answer: (1) Medium of exchange — paying for groceries with a debit card; (2) Unit of account — comparing the price of a Sydney apartment (\(1.2m) with a Melbourne apartment (\)900k) in AUD; (3) Store of value — saving AUD in a bank account to buy a car next year.

  2. A customer has $5,000 in a term deposit (fixed, cannot withdraw for 6 months) and $1,000 in a transaction account. Which amounts count toward M1, and which count toward M3? → Answer: The $1,000 transaction account balance is in M1 (and M3). The $5,000 term deposit is only in M3 — not M1 — because it cannot be spent immediately.

  3. If RBA data shows M1 = $1,200bn and M3 = \(2,800bn, what does the difference (\)1,600bn) represent? → Answer: The difference represents deposits that are in M3 but not M1 — primarily term deposits and savings accounts that cannot be immediately spent but are still part of the broader money supply.

Further Resources