Question

(a) What function of money is used for the following items/transactions?

     i) Jane spends $20 to buy drinks from a supermarket.

    ii) Jane compares the prices of drinks In Wellcome and Park'N shop, the two big supermarkets.

   iii) Jane deposits $6000 into the saving accounts for buying a new TV set one month later.

(b) Why is monetary policy ineffective under a fixed exchange rate system?

(c) Give two reasons why it is difficult for central banks to monitor asset-price inflation?

Answer 1

a-There are three basic functions of money i.e. medium of exchange, store of value and measure of value or unit of account

i-When Jane is buying drinks the money is being used as a medium of exchange. Here money became the intermediate the exchange for drinks

ii-When Jane is comparing the prices of drinks available in two supermarkets Jane is using the money as the unit of account to compare the value of the drinks in two markets.

iii-When jane is depositing into the saving account for purchasing a TV it's the store of value which will be used one month later to buy a TV set.

b) Monetary policy can either by expansionary or contractionary in nature. Suppose the central bank decides to go for an expansionary monetary policy through increasing the money supply there will be a upward pressure on the exchange rate and domestic currency will depreciate in terms of foreign currencies and the exchange rate will increase. In this case, the central bank with the objective to set back the exchange rate to its predecided position will start supplying the excess foreign currencies to the market. This means domestic currencies will come back to the central bank and money supply will decrease. This process will continue until the exchange rate falls back to its original position. Exactly the reverse happens in a contractionary monetary policy. Hence monetary policy ineffective under a fixed exchange rate system.

d) Basically, assets are financial instruments like shares, bonds and even real estate and capital goods. Asset price inflation is different from general price inflation. Some economists opine it is by default or by design. The possible causes are not limited to strategic policy making of the central bank or political decisions to get rid of inflation which is a question of debate. The two main difficulties in asset price monitoring are to recognize a bubble (inflated price of the assets) and fixing a target. In fact, there is no pre-designed mechanism available to monitor it.