Money and Money Supply (HSC SSCE Economics): Revision Notes
Money and Money Supply
Why money matters in modern economies
Money plays a fundamental role in how modern economies function. In both product markets (for goods and services) and factor markets (for resources), money provides a common way to express value. Without a stable monetary system, markets cannot operate efficiently, which directly affects economic growth over time.
When financial markets become unstable—as seen during the global financial crisis of 2008-2009—the consequences can be severe. Such instability can reduce output, increase unemployment, and lower living standards across individual countries, regions, or even globally. This demonstrates why understanding money and maintaining a stable monetary system is so important for economic performance.
The four characteristics of money
Money serves four essential functions in an economy. Understanding these helps explain why money is so important to economic activity.
1. Medium of exchange Money acts as an intermediary in transactions. Instead of bartering goods directly (swapping apples for bread), people exchange goods, services, and resources for money. This makes trade far more efficient.
2. Measure of value Money provides a common unit for comparing the worth of different items. Rather than saying "one loaf of bread equals three apples," we can express both in monetary terms (for example, bread costs $3, apples cost $1 each). This makes comparing values straightforward.
3. Store of value Money can be saved and used later. If you earn money today, you can hold it and spend it next week, next month, or next year, with reasonable confidence it will still have value. This allows people to transfer purchasing power across time.
4. Method of deferred payment Money enables credit systems and lending. People can borrow money now and repay it later. This function is crucial for investment, allowing businesses to expand and individuals to make large purchases (like homes) that they pay off over time.
All four characteristics must be present for something to function as money in an economic sense. Understanding each function helps distinguish money from other financial assets.
Understanding money supply
Most people think of money as the physical notes and coins they carry—what economists call currency. However, in economics, we focus on a much broader concept: the money supply.
The money supply refers to the total amount of funds in an economy that can serve all four functions of money (medium of exchange, measure of value, store of value, and method of deferred payment).
A common misconception: Currency (notes and coins) accounts for less than 5% of the Reserve Bank of Australia's main measure of money supply. The remaining 95% consists of bank deposits. This means most "money" in the Australian economy exists as digital entries in bank accounts, not as physical cash.
Measuring the money supply
The Reserve Bank of Australia (RBA) measures the money supply in three main ways. These are called financial aggregates (or monetary aggregates).
Money base
The money base represents the most liquid financial assets—those that can be used almost immediately for transactions. It consists of:
- All currency in circulation (notes and coins held by the public)
- All bank deposits held with the Reserve Bank
Formula for Money Base:
This is the most liquid measure because it includes only assets that can be immediately used for transactions.
M3
M3 is the Reserve Bank's main measure of money supply. It includes everything in the money base plus all deposits held by the private sector in banks (such as savings accounts, transaction accounts, and term deposits).
Formula for M3:
This measure captures the vast majority of money that Australians use for transactions and savings.
Broad money
Broad money is the most comprehensive measure. It takes M3 and adds deposits held at non-bank financial intermediaries (NBFIs) such as credit unions and building societies. However, it subtracts deposits that NBFIs themselves hold in banks (to avoid double-counting).
Formula for Broad Money:
The subtraction of NBFI deposits in banks prevents counting the same money twice in the calculation.
Credit—a related concept
Students often confuse credit with money, but they are different concepts, though closely related.
Credit is a system that allows people to defer payment for purchases. When someone takes out a loan, they receive money upfront from a lender (such as a bank). The lender then holds a credit asset—a claim to receive interest payments and the original loan amount back in the future.
From the lender's perspective, the loan is an asset (they are owed money). From the borrower's perspective, it is a liability (they owe money). The credit itself refers to the loan asset the lender holds.
Key distinction: Credit is not money. It is a promise to pay money in the future. Money is the actual medium of exchange used to settle transactions. However, credit plays an important role because it increases people's purchasing power temporarily, even though it must eventually be repaid.
Why we focus on M3
When economists and policymakers discuss Australia's money supply, they typically focus on M3. This makes sense because:
- Bank deposits account for approximately 95% of M3
- Currency in circulation accounts for less than 5% of M3
Since bank deposits dominate the money supply, understanding how banks create deposits (through lending) and how people use these deposits becomes crucial for understanding monetary policy and the broader economy.
The dominance of bank deposits over physical currency reflects how modern economies operate—most transactions occur electronically through bank transfers, debit cards, and digital payment systems rather than through cash exchanges.
Key Points to Remember:
- Money has four functions: medium of exchange, measure of value, store of value, and method of deferred payment
- Money supply is much broader than just notes and coins—it includes all funds that can perform money's four functions
- The RBA measures money supply using three financial aggregates: Money base (most liquid), M3 (main measure), and Broad money (most comprehensive)
- Bank deposits make up about 95% of M3, while currency accounts for less than 5%
- Credit is not money—it is a promise to pay money in the future through a loan agreement
Key formulas: