Functions of Money

Question 1

Define the function of money as a medium of exchange

Answer 1

Money is universally accepted as a means for purchasing goods and services, eliminating inefficiencies of the barter system.

This function allows for indirect trade and increases transactional efficiency.

Question 2

Who emphasized the medium of exchange function of money in classical economics?

Answer 2

Carl Menger.

Later formalized in general equilibrium theory.

Question 3

How does money facilitate trade?

Answer 3

By serving as a universally accepted intermediary, solving the coordination problem in trade.

This allows economic agents to transact without direct exchange of goods or services.

Question 4

What principle of Adam Smith is supported by the medium of exchange function of money?

Answer 4

The principle of division of labor.

It enables specialization in production, increasing overall efficiency and economic output.

Question 5

What does the medium of exchange function enhance?

Answer 5

Allocative efficiency by reducing transaction costs.

This helps prevent substantial deadweight losses due to market failures.

Question 6

What can erode the success of money as a medium of exchange?

Answer 6

Trust and stability.

When trust erodes, people may revert to barter or foreign currencies.

Question 7

What extreme economic situation led citizens in Zimbabwe to revert to using foreign currencies?

Answer 7

Inflation exceeding 89.7 sextillion percent annually.

Citizens resorted to using the U.S. dollar, South African rand, and bartering essential goods.

Question 8

Why is a stable medium of exchange essential for monetary policy?

Answer 8

Because money supply fluctuations influence aggregate demand and price stability.

Loss of confidence in money can lead to currency substitution and financial crises.

Question 9

Fill in the blank: Money serves as a _______ in trade.

Answer 9

universally accepted intermediary.

Question 10

True or False: The lack of money in an economy can lead to efficient exchange mechanisms.

Answer 10

False.

Without money, economies face substantial deadweight losses due to inefficient exchanges.

Question 11

What is the unit of account function of money?

Answer 11

Money provides a common standard for measuring and comparing the value of goods and services within an economy.

This function stabilizes expectations and coordinates economic calculations.

Question 12

Who highlighted the unit of account function of money?

Answer 12

Keynes and the Cambridge School.

They emphasized the importance of a unit of account in economic decision-making.

Question 13

How does money enable rational economic decision-making?

Answer 13

By assigning numerical prices, enabling individuals, businesses, and governments to assess value, compare prices, and record financial transactions.

This systematic approach is essential for effective economic calculations.

Question 14

What happens without a stable unit of account?

Answer 14

Economic decision-making becomes chaotic, making it difficult to determine relative prices and compromising trade, investment, and financial planning efficiency.

This can lead to confusion in economic transactions.

Question 15

What role did the gold standard play in the unit of account function?

Answer 15

It linked national currencies to a fixed quantity of gold, providing price stability and enhancing the unit of account function.

This ensured stable pricing across borders.

Question 16

What occurred in Weimar Germany in 1923 regarding the unit of account?

Answer 16

Hyperinflation rendered the German mark meaningless as a measure of value, with prices changing multiple times daily.

This led to the need for alternative units in economic transactions.

Question 17

Fill in the blank: When money loses its ability to function as a stable unit of account, economic actors seek _______.

Answer 17

alternatives.

This can include indexing wages and contracts to more stable currencies.

Question 18

What was one method businesses and workers in Weimar Germany used to cope with hyperinflation?

Answer 18

They resorted to indexing wages and contracts in alternative units, such as the U.S. dollar.

This was a response to the instability of the German mark.

Question 19

What is the store of value function of money?

Answer 19

Money operates as a store of value when it maintains its purchasing power over time.

Question 20

What does the stability of money’s real value depend on?

Answer 20

The stability of money’s real value depends on economic agents’ trust that money will retain its purchasing power over time.

Question 21

Why are individuals willing to accept money in exchange for goods today?

Answer 21

Individuals trust that money will still buy things tomorrow.

Question 22

What is a critical expectation for households and firms when saving?

Answer 22

Households and firms expect that money will retain a similar capacity to command resources in the future as it does in the present.

Question 23

If £100 buys a basket of groceries today, what should it ideally buy in six months?

Answer 23

It ought to buy a roughly similar basket of groceries.

Question 24

What are the macroeconomic functions affected by the store of value expectation?

Answer 24

Intertemporal allocation, investment decisions, and pension systems.

Question 25

What threats compromise the store of value function?

Answer 25

Inflation and deflation.

Question 26

How does inflation affect the store of value?

Answer 26

Inflation erodes savings and discourages long-term monetary holding.

Question 27

What behavior does deflation encourage among households?

Answer 27

Deflation encourages households to delay purchases in anticipation of further price drops.

Question 28

What impact does deflation have on firms?

Answer 28

Deflation leads firms to delay investment due to falling revenues and expectations of declining demand.

Question 29

What is a consequence of both inflation and deflation on the store of value?

Answer 29

The store of value function is compromised.

Question 30

True or False: A moderate, stable inflation rate is generally detrimental to the economy.

Answer 30

False

Question 31

Why is a moderate, stable inflation rate considered beneficial?

Answer 31

It encourages spending and investment while maintaining money’s value.

Question 32

What is the standard of deferred payment?

Answer 32

Money serves as a standard of deferred payment when it is used to denominate and settle debts that are payable in the future.

Question 33

How does the standard of deferred payment underpin the credit system?

Answer 33

It enables the formation of contracts, loans, bonds, and other financial instruments where payment is delayed over time.

Question 34

What happens to the real value of future repayments during high inflation?

Answer 34

The real value of future repayments declines, creating asymmetries between lenders and borrowers.

Question 35

How do borrowers benefit in inflationary environments?

Answer 35

They repay loans with devalued currency, diminishing the real burden of repayment.

Question 36

What negative impact do lenders face in inflationary conditions?

Answer 36

Lenders lose, which can lead to credit rationing or a premium on nominal interest rates to offset expected inflation.

Question 37

What is the effect of deflation or disinflation on debt?

Answer 37

It increases the real value of debt, potentially leading to a debt-deflation spiral.

Question 38

What is the 'debt-deflation spiral'?

Answer 38

A situation where higher real debt burdens suppress consumption and investment, deepening economic downturns.

Question 39

What historical event is cited as an example of currency instability affecting the standard of deferred payment?

Answer 39

The Latin American Debt Crisis in the 1980s.

Question 40

What issue did Latin American countries face during the debt crisis?

Answer 40

They accumulated external debt in U.S. dollars, and the collapse of commodity prices and soaring inflation increased the real burden of that debt.

Question 41

What was a significant outcome of the U.S. mortgage crisis (2007-2008)?

Answer 41

Many mortgages exceeded the value of homes, leading to mass defaults.

Question 42

What assumption led to excessive borrowing during the U.S. mortgage crisis?

Answer 42

The assumption that real estate prices would continue rising.

Question 43

What demonstrates the systemic risk propagated by financial instruments relying on deferred payment?

Answer 43

The abrupt shift in future expectations during the U.S. mortgage crisis.

Question 44

Why is the standard of deferred payment increasingly vital in modern credit economies?

Answer 44

Due to the reliance on debt-financed consumption and investment.