Question

What are the uses of money?Describe how rapid inflation can undermine money's ability to perform its three basic functions. Will current Fed's policy hinder money's ability to perform its three basic functions? Explain your rational.

Answer 1

Money refers to any item or verifiable record that is widely used and accepted in transactions involving the transfer of goods and services from one person to another and repayment of debts in a specific country or socio-economic context.

Money's plays an important function is as a medium of exchange to facilitate transactions. In a market economy without money, all transactions would have to be conducted by barter system, therefore involving a direct exchange of one product or service for another. It will create problems because to obtain a particular product or service from a supplier, one has to possess a product or service of equal value, which the supplier also desires. Consequently exchange can occur only if there is a double coincidence of wants between two transacting parties. However the likelihood of a double coincidence of wants is small and makes the exchange of products and services rather difficult, thus absence of money in a market economy will create many problems.

Rapid inflation decreases the overall purchasing power thus undermining above discussed roles. The effect of inflation on three roles played by money is as follows:

1) Store of value: Money plays the role of the most liquid asset i.e. measures how easily assets can be spent to buy products and services. Money’s value can be retained over time and is a convenient way to store wealth. Due to inflation occurs, money as a medium of exchange will begin to lose its value as people may identify that the good they receive in exchange for money is reducing in quantity or quality.

2) Unit of account: Money acts as the common standard for measurement of the relative worth of goods and service. If inflation occurs, prices will not provide accuracy to good's value

3) Medium of exchange: People have requirements and wants that they cannot produce themselves. Thus the money can be used for buying and selling of products and services. If money doesn't exist goods would have to be exchanged through the process of barter system. Money mediates trade and makes markets more effective. Due to inflation since the supply of money will have increased thus the money as a store of value will decrease, and thus will take more money to buy a good or service

Currently FED is using expansionary monetary policy tools to stimulate the economy. It aim to increases the money supply, reducing the interest rates, and increases aggregate demand. However it doesn’t appear to be any drastic changes that would hinder the money's ability to continue to perform the three functions